Reasonable Salary: The File Is the Defense, Not the Formula

Tax year 2026

The IRS has published its position on what counts as a reasonable salary for an S-corp owner-employee. The position is that a salary must be set and must be reasonable — and that nothing in the Code or the regulations says what reasonable is.

"There are no specific guidelines for reasonable compensation in the Code or the Regulations. The various courts that have ruled on this issue have based their determinations on the facts and circumstances of each case."

— IRS Fact Sheet FS-2008-25, Wage Compensation for S Corporation Officers (issued Aug. 2008)

That is a better starting point than any rule of thumb, because it says where the risk sits. If there is no number in the Code, no number is safe on its face. What makes a wage defensible is not the figure — it is the file behind it.

The reader this matters to is specific: a hybrid earner with a W-2 job and an S-corp throwing off $150,000 or more in net operating income before owner compensation. The CPA has said pay yourself something reasonable and take the rest as distributions. The question underneath is reasonable to whom — and what happens if someone at the IRS looks.

Four things below: the framework an examination runs on, the nine factors the IRS names, the file that survives an examiner, and the method that produces a defensible number. If you are still deciding whether to elect at all, that is the subject of when not to elect S-corp status.

The doctrinal framework

The statutory hook is narrower than most coverage suggests. IRC §3121(d)(1) defines "employee" to include "any officer of a corporation" — not an officer who elects the treatment, any officer. That makes this a FICA characterization question, not a deduction question — a distinction worth holding onto, because the reasonableness test most coverage quotes belongs to the excessive-compensation side of the law and does no work here. IRC §1366 passes the rest through.

From there it is a payroll-tax question. Distributions carry no FICA. Wages carry it twice — the employee tax under IRC §3101 and the employer tax under IRC §3111 — as Social Security up to the annual wage base and Medicare uncapped. The employee side alone carries 0.9% more above $250,000 of wages on a joint return, $125,000 married filing separately, and $200,000 in any other case; the employer does not match it. That last threshold is the statute's own residual category, so it takes in head of household and qualifying surviving spouse as well. All three are fixed in the statute and never indexed. Move a dollar to the distribution column and both halves go with it. What the cases test is whether the amount left in the wage column reflects the services the officer actually performed.

The exception is real and narrow. Treas. Reg. §31.3121(d)-1(b) states the general rule — "Generally, an officer of a corporation is an employee of the corporation" — and then carves out the officer "who as such does not perform any services or performs only minor services and who neither receives nor is entitled to receive, directly or indirectly, any remuneration." Such an officer "is considered not to be an employee of the corporation." Both halves of the carve-out have to hold.

Three cases carry the doctrine; the regulation marks its boundary.

David E. Watson, P.C. v. United States, 668 F.3d 1008 (8th Cir. 2012), aff'g 757 F. Supp. 2d 877 (S.D. Iowa 2010), is the anchor. A CPA working full time through his professional corporation took a wage in the low five figures while the entity distributed substantially larger sums. The government's expert valued his services substantially higher; the district court adopted the expert's valuation and the Eighth Circuit affirmed. An understated officer wage was recharacterized upward, and this is the appellate anchor for that proposition.

Glass Blocks Unlimited v. Comm'r, T.C. Memo. 2013-180, sets the floor. A sole shareholder working full time took no salary. On the holding as reported, the court recharacterized his advances into the company as capital contributions rather than bona fide loans, and payments back out as wages. Zero salary from an actively-managed S-corp is the defective posture, and the "loan repayment" label does not survive it.

The boundary is the regulation rather than a case. Its general rule is that an officer of a corporation is an employee of the corporation; the exception is the narrow, conjunctive case carved out of it. That is why the Glass Blocks rule has to say actively-managed — the exception exists, and a full-time operator drawing pay is nowhere near it.

Every case above is one the government won, and that is a fact about which disputes get litigated and reported rather than a statement about the odds: the officer who is genuinely outside the exception rarely ends up in a published opinion.

The nine factors the IRS names — and what the courts did with them

FS-2008-25 introduces its list with a word most coverage drops: "Some factors considered by the courts in determining reasonable compensation:" The current IRS S-corp compensation page carries the same nine items in the same order — but not the same introduction. The live page drops the words "considered by the courts," presenting the factors as the agency's own. That attribution now survives only in the 2008 fact sheet, and it is what this section turns on. (The page reports a 03-Mar-2026 review date, which is a page-review date rather than an effective date.)

Some, not the — and the same fact sheet says there are no guidelines in the Code or the Regulations. On the document's own terms this is a list of factors courts have weighed, not a test. A file organized to tick nine boxes is weaker than one organized to answer the question the boxes are proxies for: what would an unrelated employer have paid someone else to do this job.

In both Watson and McAlary the operative findings were hours devoted and comparable-role wage data — factors 3 and 7, which are the two a court can compute with.

The wage is also a §199A input, not only a FICA cost

IRC §199A(b)(2) sets the deduction for a business at the lesser of 20% of its qualified business income, or — this is the wage limitation — the greater of 50% of W-2 wages, or 25% of W-2 wages plus 2.5% of the unadjusted basis immediately after acquisition of qualified property. The limitation does not flip on at the threshold: it phases in above it under IRC §199A(b)(3)(B), proportionate inside the range and full only above the top.

For 2026, Rev. Proc. 2025-32 §4.26 sets that threshold at $403,500 joint and $201,750 under the row it calls "All Other Returns" — where a single filer sits, the section naming only joint, separate, and all other. The range above runs $150,000 joint and $75,000 otherwise, per OBBBA §70105(a). And it runs on taxable income, not the S-corp's profit — for this reader mostly the W-2 job, which pushes a hybrid earner into the range on income the S-corp never generated.

So the wage cuts both ways. Drive it to the floor and the 50%-of-wages figure shrinks with it, and the lost deduction can exceed the payroll tax saved. Raise it and that figure relaxes — but wages are deductible to the corporation, so each dollar also cuts QBI and shrinks the 20% amount being measured. The answer is interior, not a corner. For a specified service trade or business the deduction phases to zero above the range under IRC §199A(d)(3) and drops out. (Aggregation belongs with entity choice, not here.)

The documentation file that survives examination

The wage is defended by the file, so the file is the deliverable. Each item earns its place by defending something specific.

The last two are additions to the standard checklist and the two most often missing. Contemporaneity is the one nobody can retrofit: everything else can be produced late, and a file produced late shows on its face that it was. Owner-advance documentation catches operators who fund the company informally out of personal accounts — at this income tier, most of them.

How a defensible number is actually produced

Classify the role against an occupational code. Pull comparable-role wage data. Adjust for geography, for experience and credentials, and for hours devoted. Blend across classifications where the owner wears several hats, weighted by the time record. The output is a range, and the wage sits inside it at a point the file explains.

The public data source is the Bureau of Labor Statistics Occupational Employment and Wage Statistics program — OEWS, renamed from the older OES. No OEWS figure appears here: bls.gov returned HTTP 403 to this environment and the data was not retrieved.

That the method works is not an assertion. A court has run it.

In Sean McAlary Ltd., Inc. v. Comm'r, T.C. Summ. Op. 2013-62, the sole shareholder of a real-estate brokerage drew a substantial sum out of the company and reported no wages at all. The IRS's expert built a proposed wage from the California Occupational Employment Statistics survey — the state analogue of the same government wage data a reasonable-compensation analysis runs on. The court did not take it — and on the decision as reported, its grounds were qualitative: the owner had less industry experience than the benchmark population, the operation was modest, and market conditions rather than his own expertise drove much of the result. Factors 1 and 2, doing visible work. It then built a figure of its own from an hourly rate it considered defensible applied across a full working year. Hours times rate — factors 3 and 7, in the court's own hands.

Read that in both directions. A court adjudicated a reasonable-comp figure off government occupational wage data, so the method is judicially recognized — and it rejected the specific number the method produced. No single median is a safe harbor. The output of a defensible analysis is a defensible range, and McAlary is empirical proof of that rather than a practitioner's assertion.

Two constraints. McAlary is a summary opinion, and IRC §7463(b) provides that such a decision "shall not be reviewed in any other court and shall not be treated as a precedent for any other case." It is instructive about method; it binds nothing. And the honest counter-argument is worth sitting with: if the government's own expert, running the standard method, can land well above where a court comes out, a report is not a shield. It is evidence that a process happened — what factor 9 asks for, and far more than a rule of thumb offers.

What the operator does this quarter

No analysis has ever been run. Commission one, through a practitioner or a commercial tool. Until it exists the wage has no derivation, and factor 9 asks for exactly that.

A wage figure exists with nothing behind it. Run the method retroactively. Inside the range, the fix is filing — the report and a signed memo. Outside it, adjust prospectively with a written, dated resolution; a mid-year change is a normal corporate act when documented as one.

No comp-review memo. Write it, sign it, date it, file it. Cheapest item on the list, most often absent.

Payroll is running. Verify the cadence is regular rather than a December true-up, and that deposits are current if self-filing. Factor 6 watches the shape of the payments, not the total.

Distributions exceed the derived wage. Verify the authorization exists and the amounts are booked — then check the other direction, because if the owner has advanced money in there needs to be a note.

Taxable income is near or above the §199A threshold. Run the wage range and the wage-limitation math together rather than in sequence. The FICA-minimizing and deduction-maximizing wages are different numbers and the answer sits between them — bounded either way by the defensible range, because a §199A-optimal wage outside that range is not available at any price.

Which entity should hold the S-election in the first place is a separate matter we treat on its own.