What it is
TL;DRS-corp owner-employees must pay themselves 'reasonable compensation' for services rendered. Setting wages too low to avoid FICA is the single most common S-corp audit issue. A defensible position rests on documented data, not on a percentage rule of thumb.
There is no statutory percentage. The IRS and courts use a multi-factor analysis grounded in the value of the services performed.
Recent court decisions, Watson, Glass Blocks, McAlary, have repeatedly reset owner wages upward, with the additional FICA, interest, and penalties typically running 20-40% of the adjustment.
Who it's for
Every S-corp owner-employee. There is no size threshold below which the IRS doesn't care.
- ✓S-corp owner-operators taking distributions and modest or zero W-2
- ✓Professional practices (medical, legal, consulting) where comp is highly visible
- ✓S-corps with multiple owner-employees where comp needs to be defensible by person
- ×C-corps (different reasonableness analysis applies to deductible comp)
- ×Partnerships and LLCs taxed as partnerships (guaranteed payments handle this differently)
- ×Schedule C sole proprietors (all profit is SE-tax income anyway)
How it works
1. The nine-factor framework
Courts evaluate: training and experience; duties and responsibilities; time and effort devoted; dividend history; payments to non-shareholder employees; timing and manner of bonuses; what comparable businesses pay; comp agreements; and the use of a formula.
2. Build a comparability file
BLS Occupational Employment Statistics, Salary.com / Payscale exports, RCReports analysis, industry association surveys. The file should reflect the owner's actual role, region, hours, and revenue scale.
The IRS and courts have repeatedly accepted RCReports' methodology in recent cases.
3. Document time allocation
Owners often perform multiple roles, manager, salesperson, technician. Allocating time across roles, with comparable wages for each role, often defends a lower-than-headline-rate W-2.
Distributions are not bad. Distributions in lieu of compensation for services are bad. A documented analysis of services provided, hours worked, and market comparables for each role is the core defense.
4. Refresh annually and after material change
The defensible W-2 in 2022 is not necessarily defensible in 2026. Update the analysis as compensation, role, and the business change.
A worked example
Tyrone owns a $1.8M-revenue marketing agency S-corp in St. George, takes $60,000 in W-2, and distributes $310,000. A correspondence audit asks him to substantiate the W-2. He commissions an RCReports analysis showing 1,400 hours/yr in producer/account-management roles ($95/hr median) and 400 hours in executive role ($140/hr median).
| Current $60k W-2 | Defensible W-2 from analysis | |
|---|---|---|
| Analyzed reasonable W-2 | , | $189,000 |
| Proposed IRS adjustment | $129,000 additional wages | $0 |
| Additional FICA + penalties | $26,800 | $0 |
| Increased payroll going forward | , | $129,000 more wages = $19,700 FICA |
| One-time audit exposure avoided | $26,800 |
If Tyrone had been at $189k all along, he would have paid roughly $19,700 more in annual FICA, but avoided a $26,800 one-time audit adjustment plus interest. Going forward, his $189k position is defensible. The lesson: pay close to what the analysis supports, and keep the analysis in the file.
Limits and risks
There is no statute of limitations on FICA recovery via reasonable-comp adjustments beyond the normal three-year window, but states can extend, and back-payroll penalties stack quickly.
Family member compensation is held to the same standard. Paying a non-working spouse a W-2 is its own audit magnet.
IRS correspondence audits on this issue are increasingly common since 2021. The first request is usually a generic letter asking for documentation supporting owner W-2. A current analysis in the file resolves the audit; absence of one almost always leads to a proposed adjustment.
IRS reference
- IRC §1366Pass-through treatment for S-corp shareholders.
- IRC §3121FICA wage definitions, the tax the IRS recovers in reasonable-comp adjustments.
- Watson v. Comm'r (2012)Eighth Circuit affirmed reclassification of S-corp distributions as wages.
- Glass Blocks Unlimited v. Comm'r (2013)Tax Court used the nine-factor analysis to reset comp.