Reasonable Compensation

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An S corporation owner who works in the business must be paid reasonable compensation as wages before taking distributions. The wages carry FICA; the distributions don’t. Set the salary too low and the IRS recharacterizes distributions as wages and assesses the employment tax, penalties and interest against the corporation, which is where the officer-shareholder finds out that “the S corp saves self-employment tax” was only ever half a sentence.

The office rule that an S election makes sense above roughly $100,000 of net profit comes from this page: below that, reasonable compensation absorbs most of the profit and the election saves little. This is the procedure for setting the number, defending it, and the three places on the return where the salary level changes something other than payroll tax.

Step 1: The Law and the Cases

There is no statute setting S corporation salary. The authority is §3121(d) (an officer is an employee), Rev. Rul. 74-44 (dividends paid in lieu of salary are wages), and a line of cases in which the IRS won by recharacterizing distributions:

• Radtke v. United States, 895 F.2d 1196 (7th Cir. 1990): a lawyer took $18,000 of “dividends” and no salary from his one-person professional corporation; all of it was wages.
• Spicer Accounting v. United States, 918 F.2d 90 (9th Cir. 1990): an accountant who “donated” his services and took dividends; wages.
• Joseph M. Grey, P.C. v. Commissioner, 119 T.C. 121 (2002): same, with the Tax Court adding that the taxpayer’s characterization doesn’t control.
• Watson v. United States, 668 F.3d 1008 (8th Cir. 2012): the one that sets the modern standard. A CPA paid himself $24,000 and took $200,000 of distributions from a firm he worked full time in. The court accepted the IRS expert’s figure, $91,044, built from survey data for a comparable accountant, and rejected the taxpayer’s number because it had no analysis behind it.
• Glass Blocks Unlimited v. Commissioner, T.C. Memo 2013-180: even in a loss year, the owner who ran the company had to be paid; the “loans” he took were wages.
• Sean McAlary Ltd. v. Commissioner, T.C. Summ. Op. 2013-62: a real estate broker; the court took the IRS expert’s hourly rate but cut the hours, producing $83,200 against the IRS’s $100,755. The taxpayer’s zero was never in contention.

The pattern: taxpayers lose when the salary is zero or trivial and there is no analysis. They do better when a reasoned number exists, even one the court adjusts. The IRS has never won a case against a documented, defensible salary that was merely on the low side of a range.

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Step 2: Who Has to Be Paid

• Any shareholder who performs services for the corporation, in proportion to the services, not the ownership. A 50% owner who does nothing owes no salary; a 5% owner who runs the place does.
• Family members on the payroll: spouse and children must be paid for what they do, at what it’s worth; paying a 16-year-old $30,000 to file is the mirror image of the problem.
• A shareholder who provides only capital, or who is a passive investor, is not required to take a salary; distributions to that shareholder are not recharacterized. Document the absence of services as carefully as you would document the services.
• A single-member LLC taxed as an S corporation is identical for this purpose; the LLC wrapper changes nothing.

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Step 3: Setting the Number

The IRS’s own job aid for examiners (the 2014 Reasonable Compensation Job Aid for IRS Valuation Professionals) describes three approaches. Use the one that fits the company.

Cost approach (the one for most small businesses): break the owner’s time into the tasks actually performed (sales, bookkeeping, management, the trade itself), find the market wage for each task from a salary survey (BLS Occupational Employment Statistics by metro area is free and accepted; Salary.com, PayScale and RCReports are what examiners’ experts use), weight by hours, and add up. A contractor who spends 60% of 2,000 hours swinging a hammer at $38, 25% estimating and selling at $45, and 15% doing the books at $28 has a cost-approach salary of about $76,000.

Market approach: what a company of this size in this industry pays a non-owner to do this job. Works for a general manager role; data is thinner for small firms.

Income approach: what is left for the owner’s labor after the capital invested earns a fair return. Used in Watson-type cases for professional firms where almost all the profit is labor; produces high numbers.

What does not work: a fixed percentage of profit (the “60/40 rule” has no authority and the IRS says so), the Social Security wage base as a target, or “what the owner needs to live on.” What does work in addition to the survey: the owner’s W-2 from the last job doing the same work, offers the owner has turned down, and what the company pays its highest non-owner employee.

Factors the courts weigh (from Mayson Manufacturing, 178 F.2d 115, 6th Cir. 1949, still cited): training and experience, duties and responsibilities, time devoted, comparable pay, the company’s compensation policy for everyone else, and the economic conditions of the business. A loss year supports a lower salary; it does not support zero if the owner worked.

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Step 4: What the Salary Changes Elsewhere

Item	Effect of a higher salary
FICA / Medicare	15.3% combined up to the 2026 wage base ($184,500 (verify)), 2.9% above it, plus 0.9% above $200,000. This is the cost.
QBI deduction (§199A)	Salary is excluded from QBI, so a higher salary reduces the 20% deduction below the thresholds; above the thresholds ($201,750 / $403,500 taxable income), salary is the W-2 wages that unlock the deduction (50% of wages limit). Past the threshold, a higher salary can raise the net deduction. Run both.
Retirement plan	Employer contributions to a SEP or 401(k) are a percentage of W-2 wages, not of distributions. A $40,000 salary caps a SEP at $10,000; a $150,000 salary allows $37,500 plus the employee deferral in a 401(k). Owners who want to shelter income need salary.
Social Security benefit	Computed from wages. Thirty years of a $30,000 salary produces a small check. The payroll tax “saved” is partly a benefit forgone.
Health insurance	Premiums for a more-than-2% shareholder are deductible by the owner (above the line) only if included in W-2 box 1 wages; the deduction is limited to the owner’s wages from the corporation. No salary, no deduction.
Reasonable comp vs. accumulated distributions	Distributions in a year the salary was inadequate are the amount at risk of recharacterization. Each dollar reclassified is a dollar of wages subject to FICA and an employer penalty for the unfiled 941 amounts.

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Step 5: Payroll Mechanics

• Officer salary runs through payroll: Forms 941 quarterly, 940 annually, W-2/W-3, Colorado wage withholding (DR 1094) and unemployment insurance (officers of a corporation are covered employees in Colorado; a sole officer may be exempt by election (verify current CDLE rule)).
• Form 1120-S line 7, officer compensation, must agree with the officers’ W-2s; line 8 is other wages. A zero on line 7 with distributions on Schedule K line 16d is the audit selection pattern.
• Health insurance for a 2% shareholder: in box 1 of the W-2, not in boxes 3 and 5 (exempt from FICA under §3121(a)(2)(B) when paid under a plan), reported in box 14; deducted by the shareholder on Schedule 1. The corporation deducts it as compensation.
• HSA contributions by the corporation for a 2% shareholder: same treatment, box 1 wages, deducted by the shareholder.
• A year-end “catch-up” payroll in December is acceptable if it is real payroll (941 for Q4, deposits made); it is not acceptable to book a journal entry calling prior distributions “salary” after the fact without the payroll filings.
• Payroll service or not, the owner is personally liable for the trust-fund portion of unpaid employment taxes (§6672); this is the one place an S corporation does not shield the shareholder.

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Step 6: The File Memo

One page, written when the salary is set, updated when the facts change. It should contain: the owner’s duties by category with hours; the survey sources, the metro area, the percentile used and why; comparable salaries considered; adjustments for the company’s size, profitability and a loss year; the resulting salary; and the date. The examiner’s first information document request in a reasonable-comp exam asks how the salary was determined. “The accountant said $50,000” is the answer that loses; this memo is the answer that usually ends the exam.

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A Worked Example

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Fixing a Year That’s Already Wrong

• Before December 31: run a real payroll for the shortfall. The Q4 941 and the W-2 will show it; deposits are due on the normal schedule. Distributions already taken stay distributions; the salary is new money (or a reclassification only if the payroll filings are done for it).
• After year end, before the 1120-S is filed: a late Q4 payroll with a late deposit penalty is still better than a zero on line 7. Amend the 941s if filed.
• Prior closed years: leave them; prospectively fix the salary and write the memo. Voluntarily amending three years of payroll returns rarely improves the client’s position and the statute is running.
• On exam: the dispute is the amount, not the principle. A cost-approach analysis prepared for the exam is weighed less than one prepared when the salary was set, but it is still the thing that moves the number from the examiner’s figure toward yours.

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Questions at the desk

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Written for the Tax Shop desk; figures are for the 2026 tax year as currently published. Items marked (verify) are to be confirmed against primary sources before the figures freeze in December. Last updated October 16, 2026.