Set your S corp salary too low and the loss only runs one way. If the IRS reclassifies your distributions as wages, you owe the back payroll tax, the penalties and the interest. What you cannot do is turn round and bill the government for the difference, because the Federal Acquisition Regulation (FAR), at 31.205-6(a)(1), says compensation has to be for work performed in the current year and “must not represent a retroactive adjustment of prior years’ salaries or wages.”
Most guidance on the S corp reasonable salary question assumes the IRS is the only one looking. If you hold federal contracts the figure is judged twice, by two sets of rules that do not net off. The IRS decides what your salary should have been. The FAR decides what is recoverable.
What follows is what each test asks, and what your books have to show.
What is a reasonable S corp salary for a government contractor? It is pay that matches the work the owner actually does, set before distributions are taken, and documented well enough to defend. The IRS tests it so that payroll tax is not avoided by taking profit instead of wages. On federal contracts a second test applies: FAR 31.205-6 asks whether the same pay is reasonable for the services rendered, and it will not accept a profit share dressed as salary. One number, two standards. Setting the number is a decision for your own CPA. Making sure your records stand behind it is bookkeeping.
What entity structure actually changes in your books
Strip away the tax talk and one thing changes: how you get paid, and whether that payment leaves a payroll record.
- LLC (limited liability company). You take draws. There is no W-2 and no payroll filing.
- S-Corp. You take a W-2 salary, then distributions on top.
- C-Corp. You take a W-2 salary. Profit leaves as a dividend, if it leaves at all.
Everything else follows from that one difference. Where your pay sits in your cost pools. Whether it leaves a trail an auditor follows. Whether it holds steady from year to year. Even whether you keep a tax break you assumed was safe.
| What changes | LLC | S-Corp | C-Corp |
|---|---|---|---|
| How the owner is paid | Draws | W-2 salary plus distributions | W-2 salary; profit leaves as a dividend |
| Payroll record created | No | Yes | Yes |
| What reaches your cost pools | Whatever you document as pay for work | The salary only. Distributions stay out. | Officer pay, less anything the cap or the dividend rules remove |
| Year-to-year steadiness | Swings with cash | Set by payroll | Set by payroll |
| Qualified business income (QBI) deduction, Section 199A | Eligible, until either limit below reduces it to zero | Eligible, until the service-business limit below reduces it to zero | Not eligible |
The payroll trap that costs the most
A QBI deduction is worth up to 20% of qualified business income. That is not the same as 20% of your profit, and the difference is the salary in question. IRC 199A(c)(4) says qualified business income “shall not include reasonable compensation paid to the taxpayer”, so the pay you put yourself on comes out of the base before the 20% is applied.
On the numbers used later in this article, an owner with $500,000 of profit paying themselves $180,000 has $320,000 of qualified business income, and 20% of that is $64,000. Not $100,000. Two further rules below reduce even that, one of them to nothing.
Above an income threshold a second limit sits on top: the deduction is capped at the greater of half the W-2 wages the business paid, or a quarter of those wages plus a slice of the basis in its equipment.
Those two rules pull against each other, and that is the part worth knowing. Paying yourself more raises the wage cap and shrinks the base it applies to. Paying yourself less does the reverse. There is no setting that maximizes both, which is one more reason the number belongs with your CPA and your own figures rather than a rule of thumb.
The wage figure is the whole payroll, not the owner’s salary alone. A contractor with staff therefore has a real figure to work against. A business with no payroll at all has nothing to work with.
The trap is for the business that has almost no payroll at all. A single-member LLC with no staff, an owner taking draws, and little or no equipment has nothing on either branch of the cap. Both compute to zero, so the deduction computes to zero. That is a narrower case than it first sounds, and it is worth knowing which side of it you are on before you assume the deduction is yours.
There is a separate route to the same zero, and it is the one people know about. A specified service trade or business loses the deduction as income rises. Consulting is on that list. Engineering and architecture were written into the list and then specifically taken back out, so they are not.
That one moves in three stages, and the stage you are in decides everything. For 2026 the threshold is $201,750 for a single filer and $403,500 on a joint return. Below it, a service business takes the full deduction like anyone else. Through the next $75,000 single or $150,000 joint, it phases down. Above the top of that band, $276,750 single or $553,500 joint, a service business gets nothing at all.
One more thing about the three stages: the test runs per trade or business, not per person. An owner with two companies works it out separately for each, and sits in a different stage for each one.
Filing status also changes the answer on identical business numbers. At $500,000 of taxable income a single filer running a consultancy is past the top of the band and gets zero. A joint filer at the same $500,000 is still inside it and keeps part of the deduction.
The two rules are independent of each other. A business clear of the service-business rule still loses the whole deduction if the payroll rule catches it, and that one is decided entirely by how the owner is paid.
Key Takeaway: How you pay yourself is a bookkeeping decision with a tax price tag. Above the Section 199A income threshold there are two separate ways to lose the whole 20% deduction. A service business such as consulting loses it however much it pays in wages. And any business with no payroll loses it whatever industry it is in. Ask your CPA to run your own numbers before you assume the deduction is safe.
How to defend an S corp reasonable salary when you hold federal contracts
An s corp reasonable salary has to survive a second reader. Here is the question a government auditor asks about owner pay: how much of this was payment for work done, and how much was a share of the profits? Only the first is a cost the government helps pay for.
FAR 31.205-6(a)(6) says it plainly, and it names who it means: owners of closely held corporations, members of limited liability companies, partners and sole proprietors. If you are reading this, it is about you.
It sets three tests, not one. Pay has to be reasonable for the work actually done. It cannot be a share of profit dressed up as salary. And there is a hard ceiling over both: pay above what the Internal Revenue Code lets you deduct as compensation is unallowable outright. That last one is why an IRS challenge to your salary is never only an IRS problem.
Your structure decides how hard that is to prove.
If you run an LLC, you have the hardest job. A draw is one number. It does not say what part was wages and what part was profit. So you want a written policy that splits it, ideally set before the year starts, backed by something real: hours worked, the role you fill, what the market pays someone else to do it. The regulation does not prescribe that document. It is simply the practical way to answer the question. Without it you are asking an auditor to take the split on trust, and the whole draw is open to question.
If you run an S-Corp, the split already exists on paper. Your salary is on a W-2 and your distributions are not. The question shifts to whether the salary is big enough for the work. Set it too low and the IRS may reclassify distributions as wages. Set it too high and you push cost into your rates for no reason.
If you run a C-Corp, there is no split to defend. All owner pay runs through payroll. The only question left is whether the amount is reasonable.
Key Takeaway: Every structure passes an audit. They do not cost the same to defend. An LLC needs a written pay policy to do the work a W-2 does by itself.
Owner pay and the executive compensation cap
FAR 31.205-6(p) caps how much of an employee’s pay the government will accept as a contract cost. The word employee is doing real work there. On contracts awarded before 24 June 2014 the cap reached only senior executives. FAR 31.205-6(p)(4)(ii) applies it to “the compensation of all employees” on executive agency contracts awarded on or after that date, which is almost certainly the regime your contracts sit under.
The figure itself is set by the Administrator of the Office of Federal Procurement Policy (OFPP) under 41 U.S.C. 1127, and reaches contractors through a Defense Contract Audit Agency (DCAA) memorandum rather than originating there. For costs incurred in calendar year 2025 it is $671,000 per person [DCAA memorandum 24-PSP-009(R)].
No 2026 figure has been published, checked again on 18 August 2026. The 2025 cap remains the current official number, and any higher figure you see quoted is somebody’s estimate.
Three things about the cap catch people out.
It covers more than salary. Bonuses, deferred pay and company contributions to a defined contribution plan all count toward it.
It is one cap per person, not one per contract. Work across five contracts and you still have a single ceiling.
And it is a bookkeeping step, not only a number. Pay above the cap is unallowable. It has to come out of your indirect cost pools before you calculate your rates, not after you bill. Take care which side you remove it from. Stripping the unallowable amount out of the pool and out of the allocation base inflates the rate in your own favor, and that arithmetic creates a questioned cost instead of avoiding one.
Structure changes what you measure against the cap. For an S-Corp it is the W-2 salary plus the bonuses, deferred pay and plan contributions listed above, not the distributions. For a C-Corp it is all officer pay. For an LLC it is whatever your written policy identifies as pay for work, which is one more reason that policy matters.
How each structure hits your indirect rates
Owner pay is often the biggest single cost in a small contractor’s general and administrative (G&A) pool. So the way it moves is the way your rates move.
An LLC owner who draws $300,000 one year and $180,000 the next has not changed job. But G&A moved by a third, and every rate built on it moved too. You will be asked to explain that, and “there was more cash that year” is not an answer that helps you.
An S-Corp salary does not do this. Payroll sets it once and it repeats. Rates built on a steady number stay steady, and a steady number is far easier to support.
The rule that bites here is reasonableness, under FAR 31.201-3 and FAR 31.205-6(b), not the Cost Accounting Standards. That distinction matters more than it looks, and the note below says why.
A note on CAS. If you are a small business, the Cost Accounting Standards almost certainly do not reach you at all, and the FAQ below carries the citation.
The word worth watching is “small”. It is decided contract by contract, against the size standard for the work you are bidding, so a company is exempt on one award and covered on the next as it grows.
What does not go away is reasonableness. Nor does consistency, and it has its own hook: FAR 31.203(a) says that for contracts outside full CAS coverage, “the applicable CAS provisions in paragraphs (b) through (h) of this section apply.” So the allocation discipline reaches you through the cost principles even when CAS itself does not. Whatever method you pick for grouping and allocating indirect cost, use it the same way every year.
The payroll tax difference, in dollars
Structure does change what you pay in payroll tax. Here is what that looks like on one set of numbers.
Take a contractor with $500,000 in net profit, where the owner’s work is worth $180,000 a year in salary.
| Tax component | LLC (no election) | S-Corp | C-Corp |
|---|---|---|---|
| What the tax applies to | $461,750 (net profit x 92.35%) | $180,000 salary | $180,000 salary |
| Self-employment or payroll tax, employer and employee halves together | $36,269 | $27,540 | $27,540 |
| Difference from the LLC | baseline | $8,729 less | $8,729 less |
| Corporate tax | none | none | $64,308 |
| Tax on money paid out to the owner | none | none | $57,577 |
The whole $8,729 rests on one thing: whether $180,000 is a defensible s corp reasonable salary for the work actually done. It only holds if $180,000 is genuinely reasonable pay for the work done. Set the salary low to shrink the tax and you have not saved $8,729. You have moved the money into a category the IRS can reclassify as wages, and into a category a government auditor can question as a profit share. Reasonable pay is the condition this whole table rests on.
What this table is, and is not:
- Federal only. It excludes state tax, which changes the answer in some states, and there is a section on that below.
- It assumes one working owner. Social Security’s wage base applies per person, so a second active owner brings a second base with them. Split the same $500,000 between two working owners and the self-employment tax rises to about $59,100 rather than $36,269, because the 12.4% now runs across two caps instead of one. Multi-member LLCs, husband-and-wife firms and joint ventures all sit in this position.
- It does not show the owner’s personal income tax on profit that passes through to them. The C-Corp column does show the company’s own tax and the tax on money paid out, because those two layers are what make a C-Corp different. Half of self-employment tax is deductible against income tax, and that is not shown.
- It leaves out the 0.9% additional Medicare tax, which depends on filing status and household income.
- It uses the 2026 Social Security wage base of $184,500, a 21% corporate rate, and 23.8% on money paid out to the owner, which is the 20% top rate on qualified dividends plus the 3.8% net investment income tax. The federal figures here are current for 2026 and were checked in August 2026. The wage base is reset by the Social Security Administration each October, the compensation cap is reset by a DCAA memo that is normally issued in December, and the Section 199A thresholds are reset annually by the IRS. If you are reading this in a later year, treat every federal figure here as a starting point and check the current one.
- It is an illustration of how the mechanics work on one set of assumptions. It is not a recommendation, and your numbers will differ.
If you do convert, time it at your fiscal year boundary
Conversion is an accounting event before it is a tax event. Change structure in the middle of a year and you create a short tax year, split your rate calculations in two, and hand yourself a messy incurred cost submission.
A conversion dated to the start of a fiscal year avoids all of that. The cost accounting periods stay whole, the rates cover a full year, and there is one set of books to explain rather than two.
There is a bigger question sitting behind the timing, and the article you are reading is where most guidance stops. Converting an LLC or a sole proprietorship into a corporation is not only a tax election. It creates a new legal entity, and your contracts were signed by the old one.
FAR 42.1204(a) lists “incorporation of a proprietorship or partnership” as an example of a transfer where the Government may recognize a successor in interest through a novation agreement. The word is may. FAR 42.1204(b) also says a novation is unnecessary where ownership changes through a stock purchase and the contracting party itself does not change, so not every restructuring triggers it.
One item on that list is ours, and it is the reason to raise this here. FAR 42.1204(f)(6) lists, among the documents a novation package needs where applicable, “balance sheets of the transferor and transferee as of the dates immediately before and after the transfer of assets, audited by independent accountants.” The list is not fixed; 42.1204(g) lets the contracting officer adjust what is required. That is an accounting deliverable with a hard date attached to it, and it is far easier to produce if you knew it was coming.
Note the word independent in that requirement. The firm that keeps your books is not the firm that audits those balance sheets, and any bookkeeper who offers to do both has told you something about their grasp of the rule. What your bookkeeper does is keep the records in a state where that audit is quick and cheap rather than an excavation.
Whether your particular change needs a novation at all, and what happens to your contracts if the Government declines, are legal and contracting questions. Take those to your contracting officer and your counsel before you file anything.
State treatment
The federal picture is only part of the bill. State treatment varies enough to change which structure costs least.
The four states below are not a representative sample and are not meant to be. Virginia and Maryland are here because the Washington DC corridor holds the densest concentration of federal contractors in the country. Texas and California are here because between them they show the widest spread in how states treat the same business: Texas charges no individual income tax at all, while California taxes S-Corps at the entity level, which most of its neighbors do not. If your state is not listed, the point to take is the range, not the row.
If you incorporated in Delaware, or anywhere other than where you work. Where a company is formed and where it pays tax are two separate questions, and contractors regularly assume they are one. Forming in Delaware does not move your tax home.
You are generally taxed where you actually do business, so a Delaware corporation running its contracts out of Virginia is dealing with Virginia. What forming elsewhere does add is a second set of annual obligations in the state of formation, on top of the ones where you operate. Ask your CPA which states you have a filing obligation in before you assume the answer is one.
| State | LLC | S-Corp | C-Corp |
|---|---|---|---|
| Virginia | Pass-through | Pass-through | 6% corporate |
| Maryland | Pass-through | Pass-through | 8.25% corporate |
| Texas | Franchise tax only | Franchise tax only | Franchise tax only. No corporate income tax |
| California | $800 minimum plus an LLC fee | 1.5% plus the $800 minimum | 8.84% plus the $800 minimum |
The numbers behind those cells. Virginia imposes six percent on corporate income [Va. Code § 58.1-400]. Maryland imposes 8.25% [Md. Code, Tax-General § 10-105(b)]. Texas charges no corporate income tax at all, only the franchise tax, at 0.375% for retail and wholesale and 0.75% for everyone else. For the 2026 and 2027 reports, an entity whose annualized total revenue is at or below $2,650,000 owes no franchise tax, though it still files a Public Information Report.
California charges an $800 minimum franchise tax on all three structures, 1.5% on S-Corp net income, 8.84% on C-Corp income, and on an LLC a tiered fee set by total California income: $900, $2,500, $6,000 or $11,790.
California is the outlier. It taxes S-Corps at the entity level, which the other three states in this table do not. That charge eats into the federal payroll tax saving that drives most S-Corp elections in the first place. Note also that the California LLC fee is a flat tiered amount, not a percentage, and it is capped at $11,790 however large the business gets.
One thing this table does not cover. Virginia and Maryland both run elective pass-through entity tax programs, and Virginia’s became permanent on 20 February 2026, through the thirteenth enactment clause of the 2026 Amendments to the 2025 Appropriation Act (House Bill 29, Chapter 7). Before that, the election was due to expire on 1 January 2027. These change the comparison meaningfully for an owner in the D.C. corridor. Whether electing helps you depends on your own numbers, so put it on the list for your CPA.
There is a reason a bookkeeper cares about any of this, and it is not the tax return. FAR 31.205-41(b)(1) makes federal income and excess profits taxes unallowable, so they never belong in a cost pool. State and local taxes are treated differently: FAR 31.205-41(a)(1) makes them allowable, which means they sit in G&A and they move your indirect rates. That turns an elective pass-through entity tax into an allowability question as well as a tax question, and it is worth asking about before you elect rather than after.
Every state figure above was read on 18 August 2026 from the authority that sets it: the Virginia and Maryland codes, the Texas Comptroller, and the California Franchise Tax Board. Rates and thresholds change. Check the current figure before relying on it.
Where this stops being a bookkeeping question
Our work is what each structure does to your books, your payroll records and your rates. Past that, we would be answering questions that belong to someone else.
Three questions here are not ours to answer, and you should be suspicious of any bookkeeper who answers them.
Which entity to elect. That depends on your income, your filing status, your state, your growth plans and your family’s whole tax picture. It is a decision for your CPA, on your numbers.
Liability and asset protection. What a structure shields, and how well, is a legal question. Ask a lawyer.
Teaming, joint ventures and eligibility. Prime contractors and set-aside programs both impose structural requirements. Program rules change quickly, and the agreements are legal documents. Ask counsel.
What we do is make sure your books support whatever you choose, on the day someone asks, and that the record behind your s corp reasonable salary is already written when the question arrives.
Frequently Asked Questions
How do I document an S corp reasonable salary on a government contract?
Write down how you arrived at the figure, before the year starts. What the role is, what the hours look like, and what the market pays somebody else to do the same work. Keep the salary on payroll so your records show it as pay rather than as a transfer. That one document answers the IRS question and the FAR 31.205-6 question at the same time, which is the whole point of doing it once and doing it properly.
Does entity type change what an auditor asks me for?
It changes how hard the owner pay question is to answer, and it leaves the rest of the audit alone. A W-2 answers that question by itself: the salary sits on a payroll record and the distributions do not. A draw is a single number that needs a written policy to explain it. Everything else an auditor looks at, your timekeeping, your cost pools and your billing, works the same way whatever your entity.
How does the executive compensation cap apply to an S-Corp owner?
The FAR 31.205-6(p) cap of $671,000 for calendar year 2025 applies to pay charged to government contracts. That means your W-2 salary plus bonuses, deferred pay and company retirement contributions. S-Corp distributions are not pay under this definition, so they do not count toward the cap.
Do S-Corp distributions go into my indirect rates?
No. Only the W-2 salary enters G&A or overhead as a pay cost. Distributions stay out of the cost pools entirely, which is one reason the S-Corp split is easier to explain than a single undifferentiated draw.
Does CAS 401 apply to my small business?
Almost certainly not. 48 CFR 9903.201-1(b)(3) exempts contracts and subcontracts with small businesses from all CAS requirements. CAS gets cited at small contractors far more often than it binds them. What does apply is reasonableness under FAR 31.201-3, and the expectation that you use the same accounting method from year to year.
What happens if the IRS reclassifies my distributions as wages?
The reclassified amount becomes subject to back payroll tax, penalties and interest. For a government contractor there is a second consequence. That amount now counts as pay under FAR 31.205-6, which changes what you measured against the compensation cap and can produce questioned costs on every contract it touched.
Can I change entity type in the middle of a contract?
Yes, but the timing matters more than the decision. A mid-year change creates a short tax year and splits your rate calculations. Line the effective date up with your fiscal year start, and tell your contracting officer if the change affects how you accumulate or report costs.
The short version
An S corp reasonable salary is not only a tax decision. It arrives in your books and stays there. It sets whether your own pay leaves a record, how steady your rates are, how much work an audit takes, and in one case whether a 20% deduction survives at all.
Three moments are worth a fresh look at your structure: your first cost-type contract, the point where your timekeeping and payroll records start feeding government billing, and any year your own pay changes sharply.
Amerifusion Bookkeeping keeps books for government contractors, and we look at structure through what it does to the records: cost pools, pay documentation and audit readiness. If you are setting up, converting, or unsure whether your current books would hold up, book a discovery call.
This article is education, not tax, legal or financial advice. Entity selection depends on facts specific to you. Talk to your own CPA before you elect, and to a lawyer on liability and contracting questions.
