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S-Corp Salary vs. Distributions in 2026: The IRS Is Watching These Red Flags

  • Writer: Gregory Monaco, CPA
    Gregory Monaco, CPA
  • Dec 29, 2025
  • 2 min read

Last Updated: December 29, 2025

Quick Summary

TL;DR: 2026 is the year the IRS stops accepting "December payroll fixes" and starts using machine-learning models to flag S-Corp owners who pay themselves too little. If you're taking $30K salary and $180K distributions, that's no longer a quiet mismatch—it's a pattern the IRS now detects instantly. Essex County owners (therapists, agency owners, consultants, crypto founders) are squarely in the crosshairs.


What "Reasonable Compensation" Means in 2026

The IRS weighs multiple factors when evaluating S-Corp owner compensation:

  • The owner's core revenue-generating role

  • Time spent on operations

  • Industry wage benchmarks

  • Business profitability

  • Size of distributions vs wages

  • Presence (or absence) of staff

  • Geographic wage norms (Essex County skews higher)


Pro Tip: If the business earns $200K–$350K and the owner is the primary service provider, expect "reasonable" to land in the $85K–$140K range—not the $35K–$60K many S-Corps still try.


For a deeper breakdown of how to calculate reasonable compensation, see our S-Corp Salary vs Distributions NJ Guide.


The 2026 Red Flags IRS AI Now Detects

IRS machine-learning systems now flag these patterns automatically:

  • Distributions larger than wages

  • Wages below 40%–60% of the owner's economic contribution

  • Big December "comp fixes"

  • One-off payroll runs

  • 401(k) contributions unsupported by wages

  • W-2 health insurance missing

  • BOI showing one ownership structure / payroll showing another

  • S-Corp paying owner "contractor" payments

  • Mixing owner draws with payroll (common in Newark & Montclair)


SECURE 2.0 Changes Everything

SECURE 2.0 requires earlier elective deferrals and limits catch-up wiggle room. This means:

  • December payroll "catch-ups" are now a red flag

  • Retirement contributions must be tied to wages set early in the year

  • Payroll timing matters more than ever



When Low Salary Does Work

Rare—but legitimate exceptions exist:

  • Multiple working owners with varying day-to-day roles

  • Loss years with documented cash-flow issues

  • Heavy reliance on subcontractors (but still need owner wage support)


NJ-Specific Considerations

NJ piggybacks federal S-Corp classification but treats many federal deductions differently:

  • NJ does NOT allow the QBI deduction (20% pass-through deduction)

  • NJ reviews payroll consistency for BAIT, GIT, and CBT cross-matching

  • BAIT requires aligned wages for S-Corp owners



FAQ

Q: Can I fix my compensation in December like past years?

A: No. SECURE 2.0 + IRS AI means timing matters. December payroll "catch-ups" are now a red flag.


Q: Does NJ follow federal rules?

A: NJ piggybacks federal classification (S-Corp vs not), but its GIT rules treat many federal deductions differently.


Next Steps

Don't wait until December to fix your S-Corp compensation strategy. Schedule a consultation to ensure your 2026 compensation plan is IRS-compliant.


Gregory Monaco is a CPA specializing in small business taxation, serving S-Corp owners throughout Essex County from Livingston, NJ.

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