Tom Rodriguez runs a successful plumbing company in Johnston, Iowa. Three years ago, his accountant recommended converting to an S-Corp to "save on taxes." Tom's company generated $420,000 in net profit that year, and his accountant set his salary at $35,000—telling him this would "maximize tax savings."

Last year, the IRS audited Tom's S-Corp returns. Their determination: Tom's salary was unreasonably low for a plumbing business owner generating $420,000 in profits. They reclassified $140,000 of his distributions as wages, resulting in:

• $21,420 in additional self-employment taxes
• $14,200 in penalties and interest
• $31,500 in additional accounting and legal fees to handle the audit

Total cost: $67,120 for failing the "reasonable salary" test.

The worst part? Tom's generic accountant had simply guessed at a salary number without any analysis. No methodology. No documentation. No consideration of industry standards or Tom's actual role in the business.

When Tom came to Performance Financial after the audit, we immediately implemented proper S-Corp salary determination processes that would withstand IRS scrutiny. We wish he'd found us three years earlier.

This isn't Tom's fault. It's a systemic failure of generic accountants who know just enough about S-Corps to be dangerous. Across Des Moines, Ankeny, West Des Moines, and throughout Central Iowa, contractors are operating S-Corps with dangerously low salaries—ticking time bombs waiting for IRS examination.

What Your Generic Accountant Gets Wrong About Reasonable Salary

Here's what most small business accountants tell you about S-Corp salary: "Pay yourself around $50,000 and take the rest as distributions. That's what everyone does."

This advice is lazy, dangerous, and potentially fraudulent.

The IRS doesn't care what "everyone does." They care whether YOUR salary is reasonable for YOUR role, in YOUR industry, with YOUR level of experience, generating YOUR level of profit. Generic rules-of-thumb create massive audit exposure.

What "Reasonable Compensation" Actually Means

The IRS requires S-Corp shareholder-employees to receive "reasonable compensation" for services performed. From IRS guidance:

"Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation."

Key phrase: "reasonable compensation for services rendered."

This is not optional. It's not a suggestion. It's federal tax law with severe penalties for violation.

The IRS Reasonable Salary Factors

According to IRS Fact Sheet FS-2008-25, courts have considered these factors when determining reasonable compensation:

1. Training and Experience

• Education level and professional certifications
• Years in the industry
• Specialized skills or expertise
• Professional reputation

A master electrician with 20 years experience running a $3M company requires higher compensation than a recent trade school graduate running a $400K startup.

2. Duties and Responsibilities

• Management responsibilities
• Decision-making authority
• Client relationship management
• Risk and liability assumed

An owner managing 15 employees, handling all estimating, and personally managing $2M in active projects has materially different responsibilities than an owner of a one-person operation.

3. Time and Effort Devoted to Business

• Full-time vs. part-time involvement
• Hands-on field work vs. management-only
• After-hours availability and responsibilities
• Seasonal work patterns

A contractor working 60+ hours weekly in the business requires higher compensation than an owner who's semi-retired and works 20 hours weekly.

4. Dividend History

• Pattern of distributions vs. salary over multiple years
• Consistency of dividend payments
• Relationship between profits and distributions

Consistently taking 90% of profits as distributions while paying minimal salary creates obvious audit red flags.

5. Payments to Non-Shareholder Employees

• Salaries paid to employees in similar roles
• Comparison to field supervisors and project managers
• Industry compensation benchmarks

An owner paying their lead plumber $75,000 while taking a $40,000 owner salary on $500,000 profit fails basic reasonableness tests.

6. Timing and Manner of Paying Bonuses

• Consistency of bonus structures
• Documentation of performance criteria
• Relationship between bonuses and company performance

7. What Comparable Businesses Pay for Similar Services

• Industry-specific salary data for similar roles
• Regional compensation variations
• Company size and complexity considerations

This is the most commonly used factor and requires actual data analysis—not guesswork.

8. Compensation Agreements

• Written employment agreements for officers
• Board resolutions documenting compensation decisions
• Contemporaneous documentation of salary determinations

Generic accountants almost never document the rationale for salary amounts, creating indefensible positions during audits.

9. Use of a Formula to Determine Compensation

• Systematic methodology for salary calculation
• Consistent application across years
• Adjustment factors documented

Why Generic "Rules of Thumb" Fail Contractors

Generic accountants love simple rules because they're easy to remember and quick to implement. Here's why these common rules are dangerous:

Dangerous Rule #1: "Pay Yourself 40-60% of Profits"

Problem: This ignores industry norms, company size, and owner role. A general contractor generating $400,000 profit paying 40% salary ($160,000) is vastly different from an electrical contractor generating $400,000 where 60% salary ($240,000) might be appropriate based on industry data.

The 40-60% range is so broad it's essentially meaningless.

Dangerous Rule #2: "Match Your Previous W-2 Salary"

Problem: Your previous salary as an employee is irrelevant to reasonable compensation as a business owner. Employee salary compensates labor only. Owner salary must also compensate management, risk, capital deployment, client relationships, and strategic decision-making.

An HVAC technician earning $65,000 as an employee who starts their own company generating $350,000 profit requires substantially higher compensation as owner.

Dangerous Rule #3: "Pay Yourself $50,000-$70,000"

This is the most dangerous advice because it sounds reasonable but has zero analysis behind it. The IRS doesn't accept arbitrary numbers. They want defensible methodology based on actual data.

Dangerous Rule #4: "Minimize Salary to Maximize Tax Savings"

While technically true that lower salary reduces self-employment taxes, the IRS specifically prohibits artificially low salaries. Aggressive minimization creates maximum audit exposure.

The goal isn't the lowest salary—it's the lowest defensible salary based on objective factors.

The Performance Financial S-Corp Salary Methodology

At Performance Financial, we implement comprehensive S-Corp salary analysis specifically designed for Iowa contractors. Here's our process:

Step 1: Industry Compensation Data Analysis

Bureau of Labor Statistics Research

We start with objective government data:

• Occupation-specific wage data for your trade
• Regional adjustments for Des Moines metro area
• Experience level differentials
• Management vs. technical role distinctions

Example: For general contractors, BLS data shows:

• First-line supervisors of construction trades: $72,000-$95,000 (Des Moines metro)
• Construction managers: $95,000-$125,000 (Des Moines metro)
• Top 10% earn $140,000+ (Des Moines metro)

These provide baseline ranges before adjusting for ownership factors.

Third-Party Salary Databases

We supplement BLS data with:

• RMA Annual Statement Studies (industry-specific compensation)
• CompAnalyst construction industry reports
• Trade association compensation surveys (ABC, AGC, NAHB)
• Regional contractor salary data

Peer Company Comparisons

We analyze similar companies:

• Contractor size (revenue and employee count)
• Geographic market
• Service specialization
• Company age and maturity

Step 2: Owner Role Assessment

Operational Involvement Scoring

We quantify owner participation:

• Percentage of time in field vs. office
• Direct labor performance vs. management-only
• Project management responsibilities
• Estimating and bidding involvement
• Client relationship management
• Strategic planning and growth initiatives

Management Responsibility Evaluation

• Number of employees supervised
• Revenue managed
• Project complexity and risk
• Regulatory compliance oversight
• Quality control and safety management

Risk and Capital Analysis

• Personal guarantees on business debt
• Equipment and asset ownership
• Bonding and insurance responsibilities
• Client concentration risk management

Step 3: Mathematical Salary Calculation

Base Salary Determination

Starting point from industry data:

• BLS occupational wage for owner's primary role
• Adjustment for regional cost of living
• Experience and credential factors

Management Premium Addition

Additional compensation for:

• Supervision of employees (typically $8,000-$15,000 per employee managed)
• Revenue responsibility (typically 3-8% of gross revenue)
• Risk assumption (typically $20,000-$40,000 for personal guarantees and owner risk)

Ownership Premium Consideration

Additional factors:

• Profit allocation for entrepreneurial risk
• Capital return expectations
• Growth and development responsibilities

Reasonableness Cap

Total salary typically shouldn't exceed:

• 50-70% of company net profit (depending on industry)
• 5-12% of gross revenue (depending on margin profile)
• 150-200% of highest-paid non-owner employee

Step 4: Documentation and Justification

Written Compensation Analysis

We prepare documented rationale including:

• Industry data sources and calculations
• Owner role and responsibility assessment
• Salary determination methodology
• Comparison to objective benchmarks

Board Resolution

Formal documentation:

• Resolution approving salary amount
• Effective date of compensation
• Review and adjustment protocols
• Signature of all corporate officers

Annual Review Process

Systematic reassessment:

• Changes in owner role or responsibilities
• Company growth or contraction
• Industry compensation trend updates
• Profit level changes

This documentation creates a defensible position during IRS examination—exactly what Tom Rodriguez's accountant failed to provide.

Step 5: Integration with Tax Strategy

QBI Deduction Optimization

Qualified Business Income deduction creates tension:

• Higher salary reduces QBI deduction (QBI based on net income after wages)
• Lower salary increases self-employment tax savings but reduces QBI base

We model optimal salary balancing both factors.

Retirement Plan Contribution Maximization

SEP-IRA and Solo 401(k) employer contributions based on W-2 wages:

• Higher salary enables larger employer retirement contributions
• Retirement contribution tax benefits may justify higher salary
• Multi-year wealth building vs. single-year tax minimization

State Tax Considerations

Iowa-specific factors:

• Iowa income tax on wages vs. business income
• Iowa tax credits and incentives
• Multi-state operations creating nexus issues

Real-World Examples: Proper S-Corp Salaries for Des Moines Contractors

Let me show you what reasonable salaries actually look like for different contractor profiles:

Example #1: Ankeny Electrical Contractor

• Company Profile: $1.8M revenue, 6 employees, 15 years in business
• Owner Role: 30% field work, 70% management (estimating, project management, client relations)
• Net Profit: $280,000
• Industry Data: Electrical project managers $85K-$110K, owners $120K-$160K
• Our Calculation: $135,000 salary, $145,000 distributions
• Rationale: Owner functions as project manager + business development + operations oversight. Salary represents top 25th percentile for project managers plus management premium. Ratio (48% salary) reasonable for profitable electrical contracting.

Example #2: West Des Moines HVAC Company

• Company Profile: $3.2M revenue, 12 employees, owner + co-owner
• Owner #1 Role: Field operations, service management, 60% billable time
• Owner #2 Role: Sales, estimating, administration, 20% billable time
• Net Profit: $485,000
• Industry Data: HVAC service managers $75K-$95K, sales managers $80K-$110K
• Our Calculation: Owner #1: $115,000, Owner #2: $125,000, combined $245,000 distributions
• Rationale: Different owner roles justify different salaries. Combined salary (50% of profit) reasonable for two active owners in service business with strong margins.

Example #3: Grimes Remodeling Contractor

• Company Profile: $950,000 revenue, 3 employees, 8 years in business
• Owner Role: Hands-on carpenter 50%, project management 30%, business management 20%
• Net Profit: $175,000
• Industry Data: Lead carpenters $55K-$70K, small contractor owners $75K-$95K
• Our Calculation: $85,000 salary, $90,000 distributions
• Rationale: Owner performs significant billable labor justifying carpenter premium. Management responsibilities add $15K-$25K to base. 49% salary ratio appropriate for smaller, owner-operated business.

Example #4: Johnston General Contractor

• Company Profile: $6.5M revenue, 28 employees, 22 years in business
• Owner Role: Minimal field work, full-time management, client relations, strategic planning
• Net Profit: $720,000
• Industry Data: Construction company executives $140K-$190K, owners of similar size $180K-$240K
• Our Calculation: $210,000 salary, $510,000 distributions
• Rationale: Large company requiring sophisticated management. Owner salary comparable to construction company president plus ownership premium. 29% salary ratio appropriate for well-established, profitable company with professional management structure.

The IRS Audit Red Flags to Avoid

Based on IRS examination patterns, these situations create maximum audit risk:

Red Flag #1: Salary Below $50,000 with Profits Above $200,000

IRS computers automatically flag returns where distributions significantly exceed salary. Ratio of 4:1 or higher (distributions to salary) triggers scrutiny.

Red Flag #2: Zero or Minimal Salary with Distributions

Taking $150,000 in distributions while paying yourself $15,000 salary essentially announces "I'm avoiding self-employment taxes improperly."

Red Flag #3: Salary Lower Than Employee Wages

Paying your lead carpenter $70,000 while taking a $50,000 owner salary fails basic reasonableness tests.

Red Flag #4: Salary Unchanged Despite Profit Growth

Maintaining $75,000 salary while profits grew from $150,000 to $450,000 over three years suggests salary isn't being properly adjusted.

Red Flag #5: No Documented Salary Determination

When IRS asks "How did you determine your salary?", answering "My accountant said $60,000" is inadequate. You need documented methodology.

The S-Corp Salary Audit Defense Strategy

If you're audited on reasonable compensation, here's what you need:

Documentation Requirements

• Written salary determination methodology
• Industry compensation data supporting salary level
• Owner role and responsibility documentation
• Board resolution approving salary
• Comparison to employees and industry benchmarks
• Multi-year salary and distribution history

Negotiation Strategies

IRS often proposes adjustments based on their own calculations. Effective defense includes:

• Presenting objective industry data supporting your position
• Demonstrating systematic, reasonable methodology
• Showing consistency with comparable businesses
• Highlighting differences from IRS's overly simplified approach

Settlement Considerations

Most reasonable compensation audits settle. Understanding negotiation ranges and settlement economics prevents unnecessarily aggressive positions or premature capitulation.

Take the Next Step: Get Your S-Corp Analysis

If you're a Des Moines-area contractor currently operating an S-Corp, you need to ask yourself:

• Is my salary based on documented analysis or arbitrary guesswork?
• Can I defend my salary during an IRS audit?
• Am I optimizing the balance between salary and distributions?
• Is my salary being adjusted as my business grows?

Tom Rodriguez learned these lessons the expensive way. You don't have to.

Book your free Tax & Accounting Analysis today and get a comprehensive S-Corp salary review. We'll analyze your specific situation, provide defensible salary recommendations, and document the methodology that protects you during audits.

📞 Call: 515-949-0123
📧 Email: dvanthul@performancefinancialllc.com

Frequently Asked Questions About S-Corp Reasonable Salary

Q: What's a safe reasonable salary percentage?

A: There's no universal "safe" percentage. Industry norms vary significantly: service contractors typically 50-60%, equipment-heavy contractors 35-45%, small owner-operators 60-70%. Proper analysis considering all IRS factors is required—not arbitrary percentages.

Q: Can I change my salary mid-year if profits are different than expected?

A: Yes, but changes should be documented with board resolutions explaining the business reasons. Frequent changes or year-end manipulations create audit risk. Consider quarterly salary reviews rather than monthly adjustments.

Q: What if my business has a loss year—do I still need to pay salary?

A: If you're actively working in the business, yes. The IRS views this as you providing services that should be compensated regardless of profitability. In loss years, salary may be reduced but shouldn't be zero if you're working.

Q: Should my salary increase every year?

A: Salary should be reviewed annually and adjusted based on company performance, owner role changes, and industry trends. Automatic increases aren't required, but frozen salaries during significant profit growth create audit exposure.

Q: What if I can't afford to pay myself a reasonable salary?

A: If cash flow doesn't support reasonable compensation, S-Corp status may not be appropriate for your business. Consider remaining as LLC or sole proprietorship until profits support proper S-Corp salary levels.

Q: Can I take bonuses instead of raising my base salary?

A: Bonuses are treated as W-2 wages and are perfectly acceptable. Whether structured as base salary or base + bonus doesn't matter for reasonableness—total W-2 compensation is what's evaluated.

Q: Does my salary need to match what I paid myself as an employee before starting my business?

A: No. Owner compensation considers factors beyond technical labor: management, risk, client relationships, and decision-making. Previous employee salary is only one minor reference point among many factors.

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