Audit Risk
S Corp Reasonable Salary: What the IRS Actually Looks At (and How to Defend Your Number)
The 60/40 rule is not in the tax code. The IRS has never blessed it. Every S-Corp owner who has lost in court paid too little in salary. This page covers the actual legal standard, the losing cases, and how to build a defensible number.
Updated 17 April 2026 · Sources: IRC Section 3121, Rev Rul 74-44, IRS FS-2008-25, Watson v Commissioner (8th Cir 2012)
The contrarian opening
The “pay yourself 40% and take 60% as distributions” rule is not in the tax code. The IRS has never blessed any percentage. In every losing taxpayer case, the owner set the salary too low and the IRS reclassified distributions as wages, triggering FICA plus interest and a 20% accuracy penalty. The cost of losing a reasonable-salary audit often exceeds several years of the SE-tax saving.
The Legal Standard
Statutory basis: IRC Section 3121 defines wages subject to FICA. Treasury Regulation 31.3121(d)-1(b) identifies corporate officers as employees when they perform substantial services.
The standard: “Reasonable compensation” is the amount a hypothetical employer would pay an unrelated third party to perform the same services. It is a facts-and-circumstances test with no statutory percentage.
IRS authority: Rev Rul 74-44 and IRS Fact Sheet FS-2008-25 (S Corporation Officers) are the primary administrative guidance documents. FS-2008-25 explicitly states that corporate officers are employees and their compensation is subject to employment taxes.
The Nine Factors the IRS Examines
1. Training and experience
What credentials, education, and years of experience does the owner bring? A dental practice owner with 20 years of clinical experience commands higher compensation than a first-year associate.
2. Duties and responsibilities
Is the owner also the office manager, accounts receivable, and IT department? More roles mean a higher defensible salary.
3. Time and effort devoted to the business
An owner working 60 hours per week in a high-skill role has a higher defensible salary than one working 10 hours in a supervisory capacity.
4. Dividend history
A pattern of minimal salary with high distributions is a direct audit trigger. The IRS compares the ratio across years.
5. Payments to non-shareholder employees
If the corporation pays employees in similar roles more than the owner, that is used as a comparability data point against the owner.
6. Timing and manner of paying bonuses
Year-end bonuses sized to bring the ratio into compliance, paid after the year's income is known, are viewed skeptically.
7. Comparable wages in the market
The BLS OEWS database, industry surveys, and third-party tools like RCReports provide the benchmark. This is the most important factor in practice.
8. Compensation agreements
Written employment agreements set at arm's length before the year's income is known carry more weight than post-hoc arrangements.
9. Use of formula
A documented, consistently applied formula is defensible even if the resulting salary is modest, because it shows the salary was set on objective criteria, not to minimize FICA.
The Losing Cases (and What They Teach)
Watson v Commissioner, 8th Cir. (2012)
Facts: David Watson, a 20-year licensed CPA, owned his practice through an S-Corp. He paid himself $24,000/year and took $203,000+ in distributions across two years.
Outcome: Both the trial court and the 8th Circuit upheld IRS reclassification of $67,044 as wages. BLS data showed comparable CPAs earned $70,000-$80,000.
Lesson: Professional-services owners with BLS-benchmarkable roles face the highest scrutiny. The IRS will find the comparable wage data if you do not.
Glass Blocks Unlimited v Commissioner, TC Memo 2013-180
Facts: Owner of a glass block installation S-Corp took $0 in salary while the company made distributions and loan repayments to him. He worked full-time in the business.
Outcome: Tax Court reclassified the purported loan repayments as wages. Zero salary for a full-time working owner is the most aggressive possible position.
Lesson: Disguising compensation as loans does not work and adds a tax-motivated-transaction problem on top of the reasonable-salary issue.
Sean McAlary Ltd v Commissioner, TC Summary 2013-62
Facts: A real estate broker paid himself $24,000/year from an S-Corp while taking $240,000 in distributions.
Outcome: Tax Court increased the salary to $83,200. The IRS had sought $100,755. The taxpayer bore legal costs and interest regardless.
Lesson: Even when the IRS asks for more than the court grants, the outcome is still significantly higher than the original salary, and the taxpayer bears all costs.
How to Build a Defensible Number
Step 1: Identify the right BLS SOC code
The BLS OEWS database covers over 800 occupations. Find the SOC code that best describes your actual role. A dental practice owner who also practices dentistry maps to SOC 29-1021 (General Dentist). Use the most specific code available.
Step 2: Use MSA-level wage data for your location
BLS breaks wages down by metropolitan statistical area. A software developer in San Francisco commands a higher salary than one in rural Iowa. Use your metropolitan area, not the national average.
Step 3: Choose the appropriate percentile
The 50th percentile is the baseline. Above-average experience supports the 75th percentile. Below the 25th percentile requires a documented reason (part-time, startup phase, documented equity compensation plan).
Step 4: Consider a third-party tool
RCReports ($200-500/yr) produces documented compensation analyses specifically designed for IRS scrutiny. The cost is less than an hour of CPA time in an audit and provides an independently credentialed report you can produce on request.
Step 5: Document and repeat annually
Save the analysis in corporate records. Record the salary decision in board minutes. Revisit annually. A documented process applied consistently is substantially more defensible than an undocumented number, even if the resulting figures are similar.
What Triggers the Audit
Distribution-to-salary ratio above 3:1
Anything above 3:1 is a pattern flag across multiple years.
Salary below lower BLS quartile
Below the 25th percentile for your occupation and location is easy for the IRS to find.
Salary dropped without role change
A sudden salary reduction with no corresponding change in role or hours is a red flag.
No documented analysis
The absence of a written analysis implies the salary was set to minimize FICA, not to reflect market wages.
Professional-services industry
CPAs, attorneys, consultants, physicians, and real estate brokers face heightened scrutiny because comparable wages are easy to find.
Non-cash or in-kind payments instead of salary
Paying in-kind or through loans instead of salary has been consistently unsuccessful in court.