The question of reasonable compensation for S corporation shareholder-employees is one of the most frequently litigated issues in small business taxation. The IRS has long taken the position that S corporation shareholders who perform services for the corporation must receive reasonable compensation for those services, and that characterizing service income as distributions rather than wages is an impermissible avoidance of employment taxes.[1] The Tax Court has addressed this issue in numerous cases over the past two decades, and the resulting body of law provides both guidance and cautionary tales for S corporation owners.
Why Reasonable Compensation Matters
The reasonable compensation issue arises because of the different tax treatment of wages and distributions from S corporations. Wages paid to an employee are subject to FICA taxes (Social Security and Medicare)—currently 15.3 percent of the first $160,200 (for 2023) and 2.9 percent of wages above that threshold, plus the 0.9 percent Additional Medicare Tax on wages exceeding $200,000 for single filers. The employer and employee each pay half of the FICA tax, though in a closely held S corporation where the shareholder is both employer and employee, the economic burden falls on the same person.
Distributions from an S corporation, by contrast, are not subject to employment taxes. They pass through to the shareholder and are reported on the shareholder's individual return as ordinary income (or, in some cases, as capital gain), but they do not trigger FICA. This difference creates an incentive for shareholder-employees to minimize their wage compensation and maximize their distributions, thereby reducing the overall tax burden on the business income.
The IRS views this strategy as abusive when the compensation paid does not reflect the fair value of the services performed. The Service's position is straightforward: if a shareholder-employee performs substantial services for the corporation, the corporation must pay reasonable compensation for those services before making distributions.[2]
The Multi-Factor Test
Neither the Internal Revenue Code nor the Treasury Regulations define "reasonable compensation" with precision. Instead, the Tax Court has developed a multi-factor test that considers the totality of the circumstances. The factors most commonly cited include: the employee's qualifications, training, and experience; the nature and scope of the employee's work; the time and effort devoted to the business; the size and complexity of the business; comparable compensation paid by similar businesses for similar services; the corporation's dividend history; the economic conditions generally and locally; and the compensation paid to non-shareholder employees for comparable work.[3]
No single factor is dispositive, and the weight given to each factor varies with the circumstances. In practice, the most persuasive evidence tends to be comparable compensation data—what do similar businesses in the same industry and geographic area pay for similar services? Compensation surveys, expert testimony, and data from industry associations can all be relevant. The Tax Court has also given weight to the corporation's own compensation history, particularly where the shareholder-employee's compensation has remained flat while the business has grown substantially.
Notable Tax Court Decisions
Several Tax Court decisions illustrate the range of outcomes in reasonable compensation cases. In Watson v. Commissioner, the Tax Court found that an accountant and shareholder of an S corporation accounting firm who paid himself $24,000 in salary while receiving $203,651 in distributions was undercompensating himself. The court determined that reasonable compensation was $91,044, based on comparable compensation for accountants in the same geographic area with similar experience.[4]
In Sean McAlary Ltd. v. Commissioner, the Tax Court addressed a real estate professional who received no salary from his S corporation while taking substantial distributions. The court held that the shareholder's services were the primary income-producing factor for the business and that a reasonable salary must be paid. The court relied on industry compensation data and the shareholder's own experience to determine the appropriate level.
More recently, in Brinks v. Commissioner, the Tax Court examined a case involving an insurance agent whose S corporation paid him a salary that the IRS considered too low relative to the corporation's income. The court applied the multi-factor test and found that the salary, while low, was not so far below market as to constitute unreasonable compensation. The court noted that the shareholder performed some but not all of the corporation's service functions and that the corporation employed other individuals who contributed to its revenue.
Setting Defensible Compensation Levels
For S corporation shareholder-employees, the goal should be to establish a compensation level that is defensible under audit. Several practical strategies can help achieve this goal.
First, document the basis for the compensation determination. A contemporaneous memorandum explaining how the compensation level was set—including reference to comparable data, the shareholder's role and responsibilities, and the time devoted to the business—is far more persuasive than after-the-fact justifications developed during an audit. The memorandum should be prepared annually, particularly if the business's circumstances change.
Second, consider obtaining a formal compensation study. For larger businesses or those with compensation levels that might invite scrutiny, engaging a compensation consultant to prepare an independent analysis of reasonable compensation can provide strong support. The cost of the study is modest compared to the potential employment tax liability (plus penalties and interest) that could result from an IRS challenge.
Third, pay attention to the overall picture. A shareholder-employee who takes $50,000 in salary and $500,000 in distributions from a company where the shareholder is the only revenue-producing person presents a much more inviting audit target than a shareholder who takes $200,000 in salary and $350,000 in distributions from the same company. The ratio of salary to distributions is not the legal test, but it is often the practical trigger for IRS scrutiny.
Fourth, be consistent. Dramatic year-to-year swings in compensation, particularly decreases in salary accompanied by increases in distributions, suggest that the compensation level is being driven by tax considerations rather than by the value of the services performed. A consistent compensation level, adjusted periodically for inflation and business growth, is more defensible than one that fluctuates based on the shareholder's desire to minimize employment taxes.
The Bottom Line
The reasonable compensation issue is not going away. The IRS continues to audit S corporations on this issue, and the Tax Court continues to decide cases. For shareholder-employees of S corporations, the prudent approach is to pay compensation that reflects the fair market value of the services performed, document the basis for the determination, and resist the temptation to minimize salary to an unsupportable level. The employment tax savings from artificially low compensation are rarely worth the risk of an IRS assessment, which will include not only the additional FICA taxes but also penalties and interest that can substantially increase the total liability. Our firm regularly advises S corporation clients on compensation structuring and tax controversy defense.[5]