Setting a Reasonable S Corporation Salary Before the Last Payroll

If you own an S corporation, the last payroll of 2026 is your last chance to set this year's salary. Wages count in the year they are paid. A raise decided in January goes on next year's W-2, not this one.

That number drives your payroll taxes, your qualified business income deduction, your retirement contributions, and in California, your disability insurance withholding. The IRS can also question it years later. Here is how we set and document a salary, and what to check before the final payroll runs.

What the IRS expects

The IRS says an S corporation must pay a shareholder who works in the business reasonable compensation before making non-wage distributions. The tax code and regulations give no formula. The IRS lists factors courts weigh, including training and experience, duties, time devoted to the business, pay for non-owner employees, what comparable businesses pay for similar services, distribution history, and how bonuses are paid.

An owner who does little or no work for the company does not need a salary.

What a low salary costs

If the salary is too low, the IRS can treat part of the distributions as wages. The company then owes the Social Security and Medicare taxes that should have been paid, plus penalties and interest.

In a well-known 2012 appeals court case, David E. Watson, P.C. v. United States, a CPA paid himself $24,000 a year while taking more than $175,000 a year in distributions. The court accepted the IRS expert's figure of about $91,000 as reasonable pay, and the back taxes, penalties, and interest stood.

Overpaying has a cost too. Wages up to the 2026 Social Security wage base of $184,500 carry 15.3 percent in combined Social Security and Medicare tax, split between you and the company. Above that base, only Medicare tax continues. The goal is a defensible number, not the highest one.

How we set the number

Most owners hold several jobs, so we start by splitting the year into roles, such as general manager, estimator, and bookkeeper, with the hours spent in each. An IRS job aid for its valuation staff calls this a cost approach.

Then we price each role using Bureau of Labor Statistics wage estimates by occupation for your state or metro area. We adjust for experience and hours, then compare the result with what you pay non-owner staff and with the company's profit. A small salary next to large profits, when the owner does most of the work, is the pattern the IRS looks for.

Then we write it down: a short memo with your roles, hours, wage sources, and the final number, approved in the company's minutes. We update it when your role or the business changes.

Salary and the QBI deduction

The qualified business income deduction is now permanent under the July 2025 tax law, Public Law 119-21. Your salary is not qualified business income, and every dollar of salary also reduces the company profit that is. Below the 2026 taxable income thresholds, $201,750 for single filers and $403,500 for joint filers, a higher salary simply trims the deduction.

Above those thresholds, the deduction can be limited to the greater of 50 percent of the W-2 wages the business pays, or 25 percent of those wages plus 2.5 percent of the original cost of qualifying property. Your own salary counts as W-2 wages, so more salary can raise the limit. For specified service businesses, such as health, law, accounting, and consulting, the deduction shrinks as income rises above the threshold and is gone at $276,750 for single filers or $553,500 for joint filers in 2026. There is often a balance point, and we model it.

Retirement and health insurance follow payroll

The IRS says retirement contributions cannot be based on S corporation distributions. Your 401(k) deferral, up to $24,500 for 2026 plus catch-up contributions at 50 or older, has to come out of a 2026 paycheck. If your 2025 wages from the company topped $150,000, your 2026 catch-up contributions must go in as Roth. A SEP contribution is capped at 25 percent of W-2 pay.

Health insurance premiums the company pays for an owner with more than 2 percent of the stock also go on the W-2. When paid under a plan for employees, they are wages for income tax but not for Social Security or Medicare. Our year-end checklist also flags this. Get them on payroll before the year closes.

California adds its own math

California has no QBI deduction, but it has costs of its own. State Disability Insurance is withheld at 1.3 percent in 2026 on all wages, with no cap. If you are the only shareholder, or the only one besides your spouse, and you are an officer, you can file Form DE 459 to exclude your wages from SDI. You give up disability and paid family leave benefits in return. The exclusion starts with the calendar quarter in which the form is filed, and the choice generally holds for the rest of that year and at least the next two full calendar years.

California taxes S corporation income at 1.5 percent, with an $800 minimum, and salary reduces that income. If the company makes the pass-through entity (PTE) election, the 9.3 percent elective tax is figured on the owners' share of income after salaries, so a higher salary shrinks it. The state tax on your salary is still owed through withholding, where it falls under the federal cap on state and local tax deductions. We run the numbers both ways.

Before the last payroll runs

Your 2026 salary has to clear payroll by December 31, a Thursday this year. Christmas falls on the Friday before, and direct deposits need lead time, so confirm your provider's cutoff now.

Send us year-to-date payroll reports, distributions taken, and a profit estimate through December. If the salary needs to rise, a bonus on the final payroll can close the gap. It can also carry a larger 401(k) deferral, if your plan allows, or extra withholding. One timing rule catches companies on the accrual method: an owner's bonus booked in 2026 but paid in 2027 is generally deductible in 2027, when you report it.

Book a planning call

If you want your 2026 salary set with real numbers and a paper trail behind it, book a time with our team at calendly.com/kirkcole/15-minute-meeting.

This article is general information, not tax advice for your situation. Tax rules change, and the right move depends on your facts.