The IRS states that an S corporation shareholder who performs services for the corporation must be treated as an employee and paid reasonable compensation as W-2 wages, and that the corporation cannot avoid employment taxes by paying distributions instead (IRS, S Corporation Compensation and Medical Insurance Issues; Rev. Rul. 74-44). The IRS publishes no percentage, no dollar threshold and no safe harbor. It publishes a list of factors, reproduced in full below.
Almost every construction owner has heard the same advice: take a small salary, take the rest as distributions, save the payroll tax. The advice is not wrong so much as incomplete. The word doing all the work is reasonable, and this article sets out what the published sources actually say about it, with citations, so you can read them yourself.
The three ways money leaves a construction company.
Before the salary question makes sense, the three routes have to be separated, because they are taxed in completely different ways and contractors routinely mix them.
| Route | What it is | How it is taxed |
|---|---|---|
| W-2 wages | Payroll for work you perform in the business | Income tax, plus Social Security and Medicare on both the employee and employer side |
| Distributions | Your share of profit paid out to you as an owner | Income tax at your rate on the company's profit, no payroll tax on the distribution itself |
| Shareholder loans and draws | Money taken out and recorded as owed | Not income if genuinely a loan, but requires terms, interest and repayment to survive scrutiny |
The payroll tax saving that makes the S corporation attractive comes entirely from route two. Profit distributed to a shareholder is not subject to self employment tax, while the same dollars taken as wages are. On $200,000 of profit, the difference between calling $60,000 of it salary and calling $160,000 of it salary is real money every year.
That gap is why the IRS addresses the question directly. Its published guidance states that when an officer performing services is paid distributions instead of wages, the IRS may recharacterize those payments as wages and assess the corresponding employment taxes. The correction is not a penalty calculated on the difference. It is reclassification of the payments themselves, with employment tax, interest and penalties following from that.
What "reasonable" actually means.
The IRS publishes no percentage. There is no 60/40 rule, no 50/50 rule and no dollar threshold in the Internal Revenue Code, the regulations or IRS guidance. Those splits circulate as practitioner shorthand. They are not law and they are not cited by the IRS.
What the IRS does publish, in S Corporation Compensation and Medical Insurance Issues, is a list of factors courts have considered in determining reasonable compensation. Quoted from that page:
- 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
Read that list as a construction owner and one line is worth pausing on: payments to non-shareholder employees. It is the only factor a contractor can check without any outside data at all, because the comparison already exists inside the payroll register. If the project managers are on $95,000 and the superintendent is on $110,000, an officer salary well below both is a number the factor list invites a question about.
In Watson v. United States, 714 F.3d 1005 (8th Cir. 2012), a CPA who worked full time in his firm was paid $24,000 in wages while the entity distributed substantially larger amounts to him. The district court accepted the government's expert valuation of his services and recharacterized a portion of the distributions as wages, and the Eighth Circuit affirmed. The case is widely cited because of what the court relied on: comparable compensation for the services actually performed, rather than how the payments were labeled.
What a low salary affects beyond the tax.
Examination risk is the reason usually given for getting this right. It is not the only thing the number touches.
1. It shrinks what a bank and a surety will give you
Underwriters normalize owner compensation. When a surety reviews your financial statements to set a bonding line, and when a bank underwrites a line of credit, they look at whether the business could operate if you were replaced by a hired manager at market rate. An artificially low officer salary does not fool them, it just means your statements need adjusting and your working capital looks softer than it is. Contractors chasing capacity work hard to make their numbers legible to underwriters. Officer compensation that requires explanation works against that.
2. It interacts with the qualified business income deduction
Under IRC section 199A, the qualified business income deduction is subject, above defined taxable income thresholds, to a limitation calculated by reference to W-2 wages paid by the business. Wages therefore appear on both sides of the question: they carry employment tax, and they are an input to that limitation. Which effect dominates depends on the owner's taxable income, the entity's wage base and its qualified property, so it is a calculation rather than a rule of thumb. It is worth naming because a salary chosen only to minimize employment tax is a salary chosen without looking at half the equation.
3. It caps retirement contributions
Contributions to a 401(k) or a defined benefit plan are driven by W-2 compensation. An owner paying themselves $45,000 has capped the most tax efficient wealth transfer available to them. For an owner in their fifties looking at an exit in a decade, that constraint is usually worth more than the payroll tax saved.
4. It lowers your Social Security record
Benefits are calculated from your highest earning years of covered wages. Thirty years of understated wages produces a permanently smaller benefit. Whether that matters depends on your plan, but it should be a decision rather than a side effect.
Why paying yourself too much also costs.
The mirror error is real, particularly for owners who are cautious or who were burned by an examination once. Every dollar above reasonable is a dollar paying the full payroll tax load for no additional protection. It also inflates the labor cost that shows up in your job cost reports if the salary is coded to jobs rather than to overhead, distorting the burden rate you use to bid.
There is a further wrinkle specific to construction: an owner who works in the field and also runs the company is doing two jobs at two different market rates. Blending them into one number without documentation is what makes the figure hard to defend in either direction.
How the number usually gets built.
Because the factor list is qualitative, practice has converged on three approaches. None of them is prescribed by the IRS, and none of them produces a number that is correct for anyone but the company it was built for. They are described here so a contractor can recognize which one their own file is built on, if any.
Comparable market wage
Establish what the market pays for each role the owner performs, using published wage data. Bureau of Labor Statistics Occupational Employment and Wage Statistics for the Atlanta metropolitan area, construction industry salary surveys and trade association compensation studies are the sources typically relied on. This approach maps most directly onto the factor the IRS lists as what comparable businesses pay for similar services.
Time allocation across roles
Split the working year by role, then price each block at its market rate and weight it. An owner might spend 40 percent estimating and selling, 30 percent in operations, 20 percent in administration and finance, and 10 percent in the field. This addresses the common construction case of an owner genuinely performing several distinct jobs at several distinct market rates.
Independent compensation study
A formal analysis by a valuation professional. Typically commissioned by larger contractors, by companies with multiple shareholders paid on different terms, or where a position needs to be documented to a standard beyond an internal memo.
In each approach the figure is only half the file. The memo recording how it was reached, the data relied on, the date, and the corporate consent approving it are what make the position reviewable later. An undocumented number cannot be explained after the fact, whatever method produced it.
What you can check without an appointment.
None of the following changes anything or requires advice. They are observations you can make from documents you already have, and they tell you whether this is a live question for your company or a settled one.
- Rank your payroll register by wage. Where does the officer salary land relative to the project managers and the superintendent? That single comparison maps to a factor the IRS names explicitly.
- List the roles the owner actually performs and the rough share of the year each one takes. Most construction owners are surprised by how many distinct jobs are on the list.
- Look up those roles in BLS wage data for the Atlanta metropolitan area. It is free and public.
- Find the memo. If there is a documented basis for the current salary, and a corporate consent dated before the payroll it applies to, this is already handled. If there is not, that is the gap.
- Check the date on it. A figure set when the company was doing $1.4 million describes a different role than the same seat at $4 million.
Owner compensation is one of the few numbers in a construction business that touches tax, bonding, borrowing and retirement at once. That is the argument for setting it deliberately, with sources, rather than adopting a percentage someone repeated at a conference.
Sources
- Internal Revenue Service, S Corporation Compensation and Medical Insurance Issues (the factor list and the reclassification position)
- Rev. Rul. 74-44 (payments to a shareholder-employee in lieu of reasonable compensation)
- IRC section 3121(d)(1) (corporate officers as employees)
- IRC section 199A (the qualified business income deduction and its W-2 wage limitation)
- Watson v. United States, 714 F.3d 1005 (8th Cir. 2012)
- Bureau of Labor Statistics, Occupational Employment and Wage Statistics, Atlanta-Sandy Springs-Roswell metropolitan area
This article summarizes publicly available IRS guidance, statute and case law for general information. It is not tax advice, it does not establish a client relationship, and no figure in it is a recommendation for any particular company. Reasonable compensation turns on facts specific to the business, the role and the owner's overall tax position. Consult a CPA before changing how you are paid.