S-Corp Salary 60/40 Rule: Myth vs. IRS Standard

Part of WageProof's complete guide to S-corp reasonable compensation.

The standard for S-corp reasonable compensation sits in Treas. Reg. §1.162-7, which asks for "such amount as would ordinarily be paid for like services by like enterprises under like circumstances" and caps the deduction at what "is reasonable under all the circumstances." That language sets no ratio of salary to distributions, and neither the Code nor any court opinion applying it has supplied one.

Where Did the 60/40 Rule Come From?

Most versions say to pay yourself 60% of net profits as salary and take the other 40% as distributions. Because the split is taken off net profit, the salary it produces tracks the year's earnings and carries no information about the owner's duties, hours, or experience. No IRS document, revenue ruling, court opinion, or piece of legislative history establishes a 60/40 or 50/50 salary-to-distribution ratio. It is a rule of thumb that spread through CPA shorthand and payroll-company marketing. The 70/30 split is the same formula with a different percentage, and nothing in the Code, the regulations or the case law makes it a safe harbor either. The 80/20 split is no different: whichever side of the line the 80% sits on, the salary still moves with the year's profit rather than with the owner's duties, hours and experience.

ADP, which says it pays one in six workers in the U.S., describes the 60/40 split in its S-corp guidance, where an owner divides "their business income into two parts, with 60% designated as salary and 40% paid as shareholder distributions," then notes that "it's not officially approved by the IRS." Block Advisors publishes the same split, with the caveat that the IRS does not set it and that it shouldn't be the only input to the number.

An RCReports poll of 4,541 CPAs, EAs, and other tax professionals, published in November 2021, asked which methods of determining reasonable compensation the IRS recognizes, offering the "50/50 Rule," the "Industry Rule," and a "Safe Harbor Rule" among the choices. None of those is IRS-recognized, and 77% of respondents picked one anyway.

Why Doesn't the IRS Recognize the 60/40 Rule?

Courts decide reasonable compensation on the facts of the individual case, weighing a list of factors with no single one controlling. The approach traces back to Mayson Mfg. Co. v. Commissioner, 178 F.2d 115 (6th Cir. 1949), where the Sixth Circuit set out what a court should look at: the employee's qualifications, the nature and scope of the work, the size and complexity of the business, a comparison of salaries with the company's gross and net income, a comparison of salaries with distributions to stockholders, prevailing rates of compensation for comparable positions in comparable concerns, "the salary policy of the taxpayer as to all employees," "the prevailing general economic conditions," and, for a small corporation with few officers, what the employee had been paid in prior years. Those comparisons are inputs, not a rule: the court said the situation "must be considered as a whole with no single factor decisive." The IRS's taxpayer guidance, Fact Sheet FS-2008-25, "Wage Compensation for S Corporation Officers," carries its own list, and "the use of a formula to determine compensation" is on it. FS-2008-25 also states there are "no specific guidelines for reasonable compensation in the Code or the Regulations," and it quotes the Form 1120S instructions, under which distributions to a corporate officer "must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation."

Treas. Reg. §1.162-7(b)(2) says "the form or method of fixing compensation is not decisive as to deductibility," so a percentage is not disallowed on its face. It goes on to say that "any form of contingent compensation invites scrutiny as a possible distribution of earnings of the enterprise." A salary pegged to profit is contingent compensation, and the question it raises is whether the number the formula produced matches what the work is worth. FS-2008-25 sets one outer bound on that number: compensation "will never exceed the amount received by the shareholder either directly or indirectly."

An examiner asks what you would have to pay someone to do the owner's work. In a management consulting firm with $500,000 in revenue, one owner-employee does all of it: the selling, the client work, the invoicing and the hiring. Put the same $500,000 through a retail store and much of the work sits with a floor staff, while a large part of the receipts covers inventory the store bought and resold, so a smaller share of the hours behind that revenue is the owner's own. The 60/40 formula cannot see any of that, and it hands both owners the same salary.

In Sean McAlary Ltd., Inc. v. Commissioner, T.C. Summary Opinion 2013-62, a real-estate broker's S corp reported gross receipts of $518,189 and transferred $240,000 to its sole shareholder-employee as distributions while reporting zero wages. Part of the IRS's own expert report compared the owner's pay, as a percentage of the company's gross receipts, with officer pay at similar firms stated as a percentage of net sales. The court did not find that portion "persuasive or helpful," because the expert did not explain how comparing those two different measures would aid the court. It weighed the wage statistics in the IRS expert's report, general market conditions, the broker's somewhat limited experience and the company's modest operations, and held that an hourly rate of $40, or annual compensation of $83,200, was reasonable.

A CPA's S corporation paid him a $24,000 salary in David E. Watson, P.C. v. United States, 668 F.3d 1008 (8th Cir. 2012), while his accounting firm paid the S corporation $203,651 for 2002 and $175,470 for 2003 and the S corporation passed what was left to him as dividends. The government's expert priced his accounting work at roughly $91,044 a year using compensation surveys for the profession, and the courts affirmed that figure.

The Compliance Gap TIGTA Measured

A 2021 report from the Treasury Inspector General for Tax Administration (TIGTA) (Report No. 2021-30-042) examined processing years 2016 through 2018 and found 266,095 returns from S corporations with profits over $100,000, a single shareholder, and no officer's compensation reported, none of which had been selected for a field examination. Those owners reported roughly $108 billion in profits and took about $69 billion in distributions while running no payroll for themselves. TIGTA estimated that those returns left out nearly $25 billion in compensation and that the owners may have avoided about $3.3 billion in FICA tax. It also noted that the IRS examines less than 1 percent of S corporations.

TIGTA never names the 60/40 rule. The returns it counted reported no officer's compensation at all, and it recommended that the IRS look harder at them, which IRS management did not agree to do. FS-2008-25 gives the instruction those returns ignored: an S corporation "should treat payments for services to officers as wages and not as distributions of cash and property or loans to shareholders." It adds that courts "have consistently held" that officer-shareholders who provide "more than minor services" to the corporation and are paid for them are employees whose compensation is subject to federal employment taxes.

What the IRS Looks At

FS-2008-25 lists nine factors courts have considered in determining reasonable compensation: training and experience, duties and responsibilities, time and effort devoted to the business, dividend history, payments to non-shareholder employees, timing and manner of paying bonuses to key people, what comparable businesses pay for similar services, compensation agreements, and the use of a formula to determine compensation. We cover them one at a time in The Nine IRS Factors for Reasonable Compensation.

Bookkeeping, selling, running operations and the client work the business sells each carry a different wage. The Bureau of Labor Statistics publishes wage data for 800+ occupations across 500+ metropolitan and nonmetropolitan areas, and the IRS's expert in McAlary took his broker wage from the California survey that the state produces jointly with BLS. The same occupation pays differently from one area to the next, and within any single area the published figures run from a 10th percentile up to a 90th, a spread that reflects, among other things, workers' experience and level of responsibility. None of that describes the business itself, so the record also has to state the revenue and staffing the corporation had in the tax year under review.

How to Set the Number

Begin with the job description, listing the tasks you perform, and match each one to a BLS occupation code for your county's BLS wage area. This is what the Cost Approach (the "Many Hats" method) does, and it's one of the IRS-recognized methodologies for determining reasonable compensation. Cost Approach vs. Market Approach compares the two methods.

On $200,000 of net profit the 60/40 rule produces a $120,000 salary regardless of the owner's duties. Say the week splits between running the business and the consulting work the business sells, which BLS publishes as two separate occupations: general and operations manager, and management analyst. You price each of those roles at the BLS wage for that occupation in your county's BLS wage area and at the time you devote to it. For a quick read on your own return, pull the BLS wage for the occupation that takes up most of your week, compare it with 60% of your profit, and see how far apart the two numbers sit before you decide the ratio is doing you any favors.

Because BLS wage data is public, anyone can check a report that names the occupation code, the geographic area, the data year and the percentile. Write down the steps from each duty to each wage figure, in enough detail that a stranger to your business can follow them. Then redo the exercise every year, including a year in which your duties didn't change, using the BLS estimates published for the tax year under review. A paragraph in your corporate minutes recording that the salary was reviewed and approved on that basis puts the analysis on the corporate record with a date on it.

If you want to see the analysis run end to end, our reasonable compensation calculator matches your tasks to BLS data for your county's BLS wage area, and WageProof generates a documented report you can hand to an examiner. Reading a sample report first will tell you whether that is the kind of documentation your return needs. The methodology page sets out how those numbers are built, step by step, if you or your CPA want to check the logic before relying on it.