S-Corp Reasonable Compensation: How to Set Your Salary Without Triggering an Audit
If you operate your optometry practice as an S-Corporation, you face a tax optimization challenge that sole proprietors and partnerships don't: determining your "reasonable compensation."
Get it right, and you minimize your tax burden legally while staying fully compliant. Get it wrong, and you either overpay in payroll taxes unnecessarily or invite IRS scrutiny that can result in back taxes, penalties, and interest.
The stakes are significant. The difference between an optimized reasonable compensation strategy and a poorly planned one can mean $5,000-15,000+ in unnecessary taxes annually—or worse, an IRS audit that costs far more in professional fees, stress, and potential penalties.
Yet many S-Corp owners operate on outdated compensation figures, vague guidance from years ago, or pure guesswork. As year-end approaches, now is the perfect time to review your compensation structure and ensure it's both compliant and tax-efficient for 2025.
What Is Reasonable Compensation (And Why the IRS Cares)
When you operate as an S-Corporation, you wear two hats: employee and owner.
As an employee, you must pay yourself a W-2 salary subject to payroll taxes (Social Security and Medicare—collectively 15.3% split between employer and employee portions).
As an owner, you can take distributions of profit, which are not subject to payroll taxes—only income tax.
This creates a powerful tax-saving opportunity: minimize your W-2 salary (reducing payroll taxes) and maximize your distributions (avoiding payroll taxes on that income).
Here's the problem: If taken to the extreme, S-Corp owners could theoretically pay themselves a tiny salary ($20,000) and take the rest as distributions ($200,000), avoiding payroll taxes on the vast majority of their income.
The IRS knows this and explicitly requires that S-Corp owner-employees pay themselves "reasonable compensation" for the work they perform before taking distributions.
What the IRS regulations say:
"An officer-employee must be paid reasonable compensation for services rendered to the corporation. The compensation is deductible by the corporation and must be included in the gross income of the officer-employee."
The key phrase: reasonable compensation for services rendered.
Why the IRS audits this aggressively:
Payroll taxes fund Social Security and Medicare. When S-Corp owners underpay themselves via salary, they're effectively avoiding these taxes, which the IRS considers tax evasion.
S-Corp reasonable compensation is one of the most frequently audited areas for small businesses. The IRS has won numerous court cases against S-Corp owners who paid themselves unreasonably low salaries, resulting in reclassification of distributions as wages, plus penalties and interest.
The consequences of getting it wrong:
Set salary too low:
IRS may reclassify distributions as wages
You owe back payroll taxes (15.3% on reclassified amounts)
Penalties and interest accrue
Professional fees to resolve the audit
Stress, time, and reputation damage
Set salary too high:
You overpay payroll taxes unnecessarily
Distributions are minimized, reducing the tax benefit of S-Corp status
You essentially gave up one of the main advantages of being an S-Corp
The goal is the Goldilocks zone: high enough to be defensible as reasonable, low enough to maximize the tax benefits of distributions.
How to Calculate Your Reasonable Compensation
The IRS doesn't provide a specific formula or percentage. Instead, they offer factors to consider when determining reasonableness. Your job is to evaluate these factors and document your reasoning.
IRS factors for 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
The use of a formula to determine compensation
Let's break down how to apply these factors to your optometry practice:
Factor 1: Training and Experience
What it means: Your education, credentials, and years of experience justify higher compensation than someone with less training.
How to apply it:
You're a licensed optometrist (Doctor of Optometry degree, state licensure)
Years of experience matter: a new grad OD commands less than a 20-year veteran
Specialized training or certifications add value (fellowship, specialty certifications, advanced clinical training)
Documentation: Note your credentials and experience level. This justifies why your compensation should align with experienced optometrist salaries, not entry-level.
Factor 2: Duties and Responsibilities
What it means: What do you actually do in the practice? Clinical work only? Or clinical plus practice management, HR, marketing, finances, etc.?
How to apply it: Most practice owners wear multiple hats:
Clinical role: Examining patients, prescribing, diagnosing—this is "optometrist" work
Administrative role: Managing staff, handling finances, negotiating with vendors, marketing, strategic planning—this is "practice manager" or "executive" work
If you're doing both clinical and significant administrative work, your reasonable compensation should reflect both roles.
Documentation: Create a list of your responsibilities:
Clinical hours per week
Administrative duties and hours per week
Strategic/ownership activities
This demonstrates you're not just an optometrist—you're an optometrist + practice manager + business owner doing operational work.
Factor 3: Time and Effort Devoted
What it means: How many hours per week do you actually work in the business?
How to apply it:
If you work 40+ hours weekly in the practice (clinical + administrative), your compensation should reflect full-time work.
If you work 20 hours weekly because you have another job or you've hired associates to do most clinical work, your compensation should reflect part-time work.
Be honest here. The IRS can request calendar evidence, schedules, and time logs.
Documentation: Track your hours for a typical month:
Clinical hours
Administrative hours
Total hours per week
Use this to calculate what percentage of full-time work you perform.
Factor 4-6: Dividends, Non-Shareholder Employees, Bonuses
These factors examine the overall compensation structure of your business:
Dividend history: Are you consistently taking large distributions with tiny salary? Red flag.
Payments to non-shareholder employees: If you pay your associate ODs $120,000-140,000 but pay yourself (owner/operator OD) only $50,000 salary, that's clearly unreasonable. Your salary should be comparable to or higher than what you pay associates, adjusted for experience and responsibilities.
Bonuses: If you're paying yourself year-end "bonuses" but calling them distributions to avoid payroll taxes, the IRS may reclassify them as W-2 wages.
Documentation: Review what you pay other clinical and administrative staff. Your compensation should be in line with or above theirs (adjusted for your greater responsibilities).
Factor 7: Comparable Compensation (The Most Important Factor)
What it means: What do other optometrists with similar duties earn in your region?
This is the most heavily weighted factor in IRS audits and court cases. If you can demonstrate that your salary aligns with what the market pays for similar work, you have a strong defense.
How to determine comparable compensation:
Source 1: Industry salary data
Research what employed optometrists earn in your region:
AOA (American Optometric Association) salary surveys
ODs on Finance salary data
State optometry association surveys
BLS (Bureau of Labor Statistics) data for optometrists in your state
Recruiting firms or job postings for OD positions in your area
For 2024-2025, general benchmarks:
Entry-level OD (0-3 years): $110,000-130,000
Mid-career OD (4-10 years): $130,000-160,000
Experienced OD (10+ years): $150,000-180,000+
OD with ownership/management duties: Add 20-40% premium
These vary significantly by region (higher in urban/coastal areas, lower in rural markets).
Source 2: What you'd pay to replace yourself
Ask yourself: "If I left tomorrow, what would I need to pay someone to do my clinical work?"
Then ask: "What would I need to pay someone to do my administrative/management work?"
Add those together. That's a reasonable starting point for your total compensation.
Example calculation:
Your role:
30 clinical hours/week examining patients
10 administrative hours/week (managing staff, finances, operations)
Market rates:
Employed OD in your area: $140,000/year for 35 clinical hours/week
Practice manager in healthcare: $65,000/year for full-time admin work
Your calculation:
Clinical component: 30 hours ÷ 35 hours = 85.7% of full-time OD = $140,000 × 0.857 = $120,000
Admin component: 10 hours ÷ 40 hours = 25% of full-time manager = $65,000 × 0.25 = $16,250
Reasonable compensation estimate: $136,250
You might round to $135,000-140,000 for your W-2 salary, then take remaining profit as distributions.
Factor 8-9: Compensation Agreements and Formulas
What it means: Do you have a written compensation policy? Have you documented how you determine your salary?
How to apply it:
The IRS looks favorably on S-Corps that have:
Written compensation policies approved by the board (even if you're the only director)
Clear formulas or methodologies for setting compensation
Annual reviews and adjustments based on business performance
Documentation:
Create a simple compensation policy document:
[Your Practice Name] S-Corporation
Shareholder-Employee Compensation Policy
Purpose: This policy establishes the methodology for determining reasonable compensation for shareholder-employees who perform services for the corporation.
Methodology:
Reasonable compensation for shareholder-employees is determined annually based on the following factors:
Comparable market compensation: Research of salary data for optometrists with similar experience, credentials, and responsibilities in [your region]
Time devoted: Estimated hours per week performing clinical and administrative duties for the corporation
Responsibilities: Consideration of both clinical optometric services and practice management/executive duties
Current Compensation (2025):
Based on the above methodology, the Board has set reasonable compensation for [Your Name] at $[X] annually, paid via regular payroll subject to all applicable payroll taxes.
This amount is reviewed annually and adjusted as necessary to remain consistent with market rates and responsibilities.
Approved by Board: [Date]
Signed: [Your signature as Director]
This one-page document, kept in your corporate records, demonstrates you've thoughtfully considered reasonable compensation using IRS factors.
The Practical Formula Most Practices Use
While every situation is unique, here's a rule-of-thumb formula that works for many solo or small optometry practices:
Reasonable W-2 Salary = (Market rate for employed OD with your experience) × (% of full-time clinical hours you work) + (Premium for ownership/management duties)
Example 1: Full-time owner-operator OD
Market rate for employed OD (your experience level): $150,000
You work full-time clinically (35+ hours/week): 100%
You also handle all practice management: Add 20% premium
Reasonable compensation: $150,000 × 1.2 = $180,000
Example 2: Part-time owner with associate doing most clinical work
Market rate for employed OD: $150,000
You work 15 clinical hours/week: 43% of full-time
You handle practice management: Add $30,000 for admin role
Reasonable compensation: ($150,000 × 0.43) + $30,000 = $94,500
Example 3: Owner working in practice but delegating significant admin
Market rate for employed OD: $140,000
You work 30 clinical hours/week: 85% of full-time
You handle high-level strategy but office manager does day-to-day admin: Add 10% premium
Reasonable compensation: $140,000 × 0.85 × 1.1 = $131,000
Common Reasonable Compensation Mistakes
Mistake #1: Using a percentage of net income
Some accountants suggest "pay yourself 30-40% of net income as salary, take the rest as distributions."
The problem: The IRS explicitly rejects this approach. Reasonable compensation isn't based on your business's profitability—it's based on what your services are worth in the market.
If your practice has an exceptionally profitable year ($500,000 net), you don't suddenly deserve $200,000 salary if the market rate for your services is $140,000.
Conversely, if your practice has a tough year ($80,000 net), you still need to pay yourself reasonable compensation based on market rates—you can't pay yourself $30,000 salary just because profits are low.
Mistake #2: Paying yourself the same salary for years without adjustment
If you set your salary at $100,000 in 2018 and never adjusted it, that's a problem.
Why:
Inflation has increased market rates
Your experience level has increased
Your responsibilities may have changed
Salary should be reviewed annually and adjusted to reflect current market conditions.
Mistake #3: Dramatically different compensation between comparable shareholder-employees
If you have a partner S-Corp where both partners are ODs working similar hours with similar experience, but one pays themselves $180,000 salary and the other $80,000 salary, the IRS will question why.
Compensation should be proportional to services rendered.
Mistake #4: No documentation whatsoever
Many S-Corp owners have never documented how they determined their salary. When audited, they have no defense except "my accountant told me this number."
Always document:
Salary data you researched
Hours you work
Duties you perform
The formula or methodology you used
Even a simple one-page memo in your files is infinitely better than nothing.
What If You've Been Paying Yourself Too Little?
If you review your compensation and realize you've been under-paying yourself (W-2 salary below reasonable levels), you need to correct it.
How to fix it:
Option 1: Catch-up payroll before year-end
Run additional payroll before December 31 to bring your total W-2 salary up to a reasonable level for 2025.
Example:
Current YTD salary: $90,000
Reasonable compensation: $140,000
You need to pay yourself an additional $50,000 via payroll before December 31
This subjects the $50,000 to payroll taxes (ouch), but it's better than an IRS audit.
Option 2: Adjust prospectively starting in 2026
If it's too late in 2025 to fix it (you're reading this in late December), accept that 2025 is what it is, but commit to correcting your salary for 2026.
Set your 2026 salary at the reasonable level, document your methodology, and move forward compliant.
Should you file amended returns for prior years?
Consult your CPA. In most cases, if you were slightly under reasonable compensation in prior years, it's not worth the complexity of amending. Just correct it going forward.
If you were egregiously under-compensated (e.g., $40,000 salary on $300,000 net income), discuss with your CPA whether proactive correction via amended returns reduces your audit risk.
What If You've Been Paying Yourself Too Much?
If you realize you've been paying yourself more than necessary (W-2 salary above market rates for your services), good news: you're fully compliant, just not tax-optimized.
What to do:
Reduce your salary prospectively for 2026 to a more optimal level (still reasonable, but not excessive).
You've overpaid payroll taxes in prior years, but there's no practical way to recover that. Just optimize going forward.
The Year-End Reasonable Compensation Checklist
Before December 31, work through this checklist:
☐ Calculate your total 2025 net income (estimated if year isn't closed yet)
☐ Determine your current YTD W-2 salary
☐ Research market rates for ODs with your experience and responsibilities in your region
☐ Document your typical weekly hours (clinical + administrative)
☐ Calculate what reasonable compensation should be using market data and your hours
☐ Compare your current salary to reasonable compensation:
If within 10-15%, you're fine
If significantly under, run catch-up payroll before year-end
If significantly over, adjust down for 2026
☐ Document your methodology in a simple compensation policy or memo for your records
☐ Discuss with your CPA to confirm your reasoning is sound
☐ Set your 2026 salary to reflect reasonable compensation, and schedule a reminder to review annually
Working With Your CPA
Your CPA should be your partner in determining reasonable compensation, but remember: you are ultimately responsible.
Questions to ask your CPA:
"Based on my practice's net income, time I work, and duties I perform, what salary range do you think is defensible as reasonable compensation?"
"What documentation should I keep to support our compensation decision if the IRS ever audits?"
"Should I adjust my salary before year-end, or can we set a better number for next year?"
"Do you have access to salary data for ODs in my area, or should I provide that research?"
Red flag CPA responses:
If your CPA says "just pay yourself 30% of net income" without any analysis of market rates or your specific situation, push back. That's not a defensible methodology.
If your CPA can't explain why your salary is reasonable based on IRS factors, find a CPA who specializes in S-Corps and understands the nuances.
Real-World Examples
Practice A: Solo OD, Full-Time Clinical and Admin
Net income: $280,000
Owner works: 35 hours/week clinical, 10 hours/week admin
Market rate research: ODs with 15 years experience in region earn $145,000-160,000
Reasonable compensation: $165,000 (mid-range of market rate + premium for management duties)
W-2 salary: $165,000
Distributions: $115,000 (saves 15.3% payroll taxes on this amount = $17,595)
Outcome: Defensible compensation based on market data, solid tax savings, fully compliant.
Practice B: Owner with Multiple Locations, Mostly Delegated
Net income: $450,000
Owner works: 10 hours/week clinical, 15 hours/week high-level strategy/oversight
Market rate research: Part-time ODs earn $70,000-80,000 for 10 hours weekly; healthcare executive oversight worth $60,000
Reasonable compensation: $130,000 (part-time clinical + executive oversight)
W-2 salary: $130,000
Distributions: $320,000 (saves 15.3% payroll taxes on this amount = $48,960)
Outcome: Strong tax savings, well-documented reasoning for part-time compensation, compliant.
Practice C: New Practice, Breaking Even
Net income: $45,000 (barely profitable)
Owner works: Full-time, 40+ hours/week
Market rate research: Employed ODs in region earn $130,000-150,000
Reasonable compensation: Can't afford market rate, but must pay something reasonable
Decision: Pay $75,000 salary (below market, but reasonable given cash constraints of new business), take $0 distributions (nothing left)
Outcome: Not optimal, but reasonable given business stage. Document that compensation is below market due to cash flow constraints of startup, and plan to increase as practice matures.
Important note: Even if your business barely profits, you still must pay yourself reasonable compensation. You can't avoid payroll taxes just because the business isn't profitable.
Final Thoughts: Sleep Easy
S-Corp reasonable compensation doesn't have to be stressful or mysterious.
Do the research. Document your thinking. Set a salary that's defensible based on market rates and your actual duties. Review it annually.
When you can confidently explain to the IRS (should they ever ask) why your salary is reasonable based on IRS factors and market data, you'll sleep easy knowing you're both compliant and tax-efficient.
Take an hour this week to review your 2025 compensation. If it needs adjusting, handle it before year-end.
Your future self—and your accountant—will thank you.
