S-Corp Reasonable Compensation: Fix It on the Last December Payroll

S-corp reasonable compensation is set on the last payroll of the year, and after December 31 it can’t be changed. That final December run is the last chance to bring the owner’s salary to a defensible level, put the owner’s health insurance on the W-2 where it has to be, and get a retirement deferral out of a paycheck that actually exists. In April, when the preparer notices the salary was too low, all three are gone for the year.

We run an accounting firm that does payroll and the return for the same S-corp owners, and the December true-up is on our calendar for every one of them. Here’s what gets decided and why it has to happen now.

How much salary should an S-corp owner take?

A reasonable amount for the work you actually perform. The IRS doesn’t publish a number or a percentage. The test is what you’d have to pay someone else to do your operating job: the hours, the responsibilities, the skills, the going rate in your area. An owner who runs the shop, sells the work, manages the crew, and does the books on Sundays is doing a job that has a market wage, and the salary should look like it.

The reason it matters is the split. An S-corp owner gets paid two ways: salary, which is subject to Social Security and Medicare taxes, and distributions, which aren’t. The tax savings of an S-corp come from the distribution side. The IRS’s position is that you can’t take all of it that way: the salary has to be reasonable first, and then whatever’s left can be distributed.

Owners who take a small salary and large distributions all year have a problem the IRS can reclassify. Distributions get recharacterized as wages, back payroll taxes and penalties get assessed, and the cost is more than the payroll tax would have been. The catch-up on the final December payroll is how the split gets fixed before anyone else looks at it.

Can I fix my S-corp salary in December?

Yes. Salary paid on any payroll dated in 2026 counts as 2026 wages, so a catch-up paid on the last December run brings the year’s total to whatever it needs to be. If you’ve taken $30,000 in salary and $120,000 in distributions, and the defensible number for your role is closer to $70,000, a $40,000 payroll in December, with the payroll taxes withheld and deposited, makes the year right.

The mechanics: the catch-up is a real payroll, run through the same system, with federal and state withholding, both halves of Social Security and Medicare, and the deposit made on the normal schedule. The cash has to be there, which is why it belongs on the December cash forecast next to the bonus run. And it has to be done from a real profit number, which means October closed and November nearly closed, because the salary should be reasonable against what the business actually earned, not against a guess.

After December 31, nothing can be done. A January payroll is 2027 wages.

How is S-corp owner health insurance reported?

Through payroll, on the W-2. For a more-than-2% shareholder, health insurance premiums the company pays, or reimburses, are added to the owner’s Box 1 wages. They’re not subject to Social Security and Medicare tax if the plan is set up properly, so the cost is only the reporting. The owner then deducts the premiums on their personal return as self-employed health insurance.

Skip the W-2 step, and the deduction is lost. The company paid the premiums, the owner didn’t report them as wages, and the personal deduction isn’t available because the amount never appeared on the W-2. It’s one of the most common things we find in a first year with a new S-corp client, and it costs real money every year it’s missed.

The fix is a payroll adjustment before the last run: the year’s premiums added to wages, so the W-2 that goes out in January is right. That’s a December task, because the W-2 is built from the payroll records as of December 31.

Retirement deferrals

An owner’s 401(k) employee deferral has to come out of a paycheck. Not a distribution, not a transfer from the business account: a payroll deduction, on a payroll dated in the year. An owner who’s taken almost no salary has had almost no paycheck to defer from, and the deferral room is limited by wages.

The December catch-up solves that too. A larger December payroll creates the wages the deferral can come out of, and the plan has to exist by December 31 for the deferral to count. The employer contribution, on the other hand, can wait until the return is filed. So the sequence is: plan opened, salary set, deferral elected, all on the last payroll of the year.

The trade

More salary means more payroll tax: both halves of Social Security and Medicare, 15.3% combined up to the Social Security wage base, on every additional dollar of wages. That’s the cost of a defensible number. It’s real, and it’s why owners push the salary down.

What it buys is a return that stands up, a W-2 that supports the health insurance deduction, a retirement contribution that’s actually allowed, and, for owners at higher incomes, wages that support the qualified business income deduction’s W-2 wage limitation. Against the alternative, a reclassification with penalties and interest a few years from now, the payroll tax on a reasonable salary is the cheaper outcome. The goal isn’t the lowest salary. It’s the lowest defensible one, set on purpose.

What a CFO does with this number

A fractional CFO sets owner pay in November, every year, as part of the planning meeting, from October’s closed books. Salary at a defensible level for the role. Health insurance through payroll. The deferral sized to the plan and the cash. Distributions for the rest, timed against the cash forecast so the December true-up doesn’t collide with the bonus payroll.

Then the estimate gets rebuilt, because the salary change moves the numbers, and the January 15 payment reflects it. Owner pay stops being whatever was left over and becomes a decision with a reason behind it.

Where we come in

Our S-corp clients have payroll and the return with the same firm, so the true-up actually happens: the salary decision made in November is the payroll run in December is the W-2 in January is the return in March. Nobody discovers in April that the health insurance never hit the W-2, because the people preparing the return are the people who ran the payroll. If your salary has been whatever was left after distributions, reach out. We’ll look at the year so far and tell you what the December run should be.

Frequently asked questions

How much salary should an S-corp owner take?
A reasonable amount for the work actually performed, roughly what you’d pay someone else to do the operating job, before taking distributions.

Can the salary be fixed in December?
Yes; a catch-up on the final payroll of the year counts for the year, but after December 31 it can’t be changed.

How is owner health insurance handled?
For more-than-2% shareholders it runs through payroll and appears on the W-2, otherwise the deduction is lost.