Methodology

Under 26 U.S.C. § 162(a)(1), businesses may deduct “a reasonable allowance for salaries or other compensation for personal services actually rendered.” For S-Corporation owner-employees, reasonableness is judged by what would ordinarily be paid for like services by like enterprises under like circumstances (Treasury Regulation § 1.162-7(b)(3)) — in practical terms, what it would cost to hire someone else to perform the work the owner does.

S-Corporations pass through income to shareholders, who pay income tax but not self-employment tax on distributions. The IRS requires that owner-employees pay themselves reasonable compensation as W-2 wages — subject to FICA taxes (Social Security and Medicare) — before taking distributions. When compensation is set unreasonably low, the IRS may reclassify distributions as wages, assess back payroll taxes, and impose penalties and interest.

There is no statutory formula for “reasonable.” The determination is inherently factual, based on the nature of the services performed, the owner’s qualifications, and comparable market data. The IRS and the Tax Court have established analytical frameworks for this determination, which this tool implements using publicly available wage data.

Courts and the IRS evaluate reasonable compensation through a multi-factor analysis rather than a single test. The nine factors below are the list the IRS summarizes in Fact Sheet FS-2008-25. The multi-factor approach itself traces to early appellate cases such as Mayson Mfg. Co. v. Commissioner, 178 F.2d 115 (6th Cir. 1949), which held that reasonableness turns on the totality of the facts. The IRS’s own nine-factor list appears separately in Fact Sheet FS-2008-25. No single factor is determinative; the IRS weighs them together based on the facts and circumstances of each case.

The Cost Approach decomposes the owner’s role into the specific business functions performed and prices each function independently using BLS wage data at the appropriate skill level and geographic location. The IRS Job Aid refers to this approach as the Cost Approach: the cost to replace the owner’s services by hiring separate individuals to perform each function.

This approach fits small S-Corporation owners who perform multiple business functions. Most small business owners divide their time across administrative, operational, financial, and specialized tasks — no single occupation classification captures the full scope of their work. The Cost Approach accounts for this by valuing each function at its own market rate rather than forcing a single job title onto a multi-function role.

The Market Approach compares the owner’s overall position to a single comparable occupation in their geographic area. Rather than decomposing the role into tasks, it identifies the primary occupation that best describes the owner’s function and applies the BLS wage for that occupation at the owner’s experience level.

The two approaches can produce different figures, and neither reliably runs higher than the other: the Cost Approach blends the wages of every function the owner performs (including lower-wage operational tasks), while the Market Approach prices the single closest comparable role. Running both frames a range to evaluate — the Cost Approach represents the replacement cost of the owner’s actual work mix, while the Market Approach represents what a single comparable professional would earn.

The IRS Job Aid notes that “the reconciliation in the case of Reasonable Compensation will generally rest heavily on the market approach.” Each report applies one approach; the owner and their tax professional can run the analysis under more than one of these approaches and compare the results to choose the figure most appropriate to their circumstances.

The Income Approach asks whether a hypothetical independent investor would consider the owner’s compensation reasonable given the return generated by the business. Rather than pricing the owner’s labor directly, it works backward from business performance: if the company’s return on equity exceeds what an outside investor would expect, the owner’s salary may be too low.

The independent-investor framing comes from Exacto Spring Corp. v. Commissioner(196 F.3d 833, 7th Cir. 1999), where the Seventh Circuit reasoned that when “the investors in his company are obtaining a far higher return than they had any reason to expect, [the owner’s] salary is presumptively reasonable.” The test is often stated, in the words of Elliotts, Inc. v. Commissioner(716 F.2d 1241, 1245 (9th Cir. 1983)), as whether “an inactive, independent investor would be willing to compensate the employee as he was compensated.” Exacto and Elliotts were excessive-compensation cases — the question there was whether pay was too high — but the same investor-return logic applies symmetrically to test whether an owner’s salary is too low.

This approach is most useful when comparable wage data is unavailable for the owner’s role, or when the owner drives outsized returns that are not fully captured by labor-market comparisons. It provides a complementary data point alongside the Cost and Market Approaches.

This mapping anchors the wage percentile to a documentable, verifiable fact — years of experience performing that specific function — rather than a subjective self-assessment of skill level. “I have 4 years of bookkeeping experience” is more readily substantiated than “I am an average bookkeeper.”

The proficiency level is set independently for each task. An owner might have 15+ years of experience in their core professional function (Expert, 90th percentile) while having only 2 years of experience managing employees (Developing, 25th percentile). The Cost Approach captures this nuance.

Note: The experience-year thresholds defining each level are informed judgments designed to provide reasonable anchors, not empirically derived cutoffs. They are intended to produce a more documentable basis for percentile selection than subjective self-assessment.

Percentile suppression:In some cases the BLS does not publish a wage for an individual percentile even when other percentiles for the same occupation are available — for reasons including insufficient sample size and data-quality or confidentiality screens. When the percentile mapped to the owner’s proficiency level is unavailable, the median (50th percentile) wage is used as a substitute. This substitution is documented in the report’s Data Substitutions section for each affected task.

Annual hours are capped at 2,080 — the standard full-time equivalent of 40 hours per week for 52 weeks. This matches how BLS wage data is structured and the standard full-time-year basis used in reasonable-compensation analyses, including by the IRS expert in McAlary (below).

In Sean McAlary Ltd., Inc. v. Commissioner(T.C. Summary Opinion 2013-62), both sides built the figure on a 2,080-hour work year; the Tax Court set $40/hour on that basis ($83,200) even though the shareholder worked roughly 12-hour days, often seven days a week. The court adjusted the hourly rate, not the hours — 2,080 was the parties’ full-time-year basis, not an hours cap the court imposed.

Owners who work fewer than 2,080 hours annually may enter their actual hours. Compensation scales proportionally: an owner working 1,040 hours (half-time) would receive approximately half the full-time compensation figure, as each task’s hours allocation is reduced accordingly.

BLS OEWS wage estimates carry a May reference date and are published roughly a year later; the survey pools six semiannual panels (May and November) collected over three years. For reports covering tax years after the survey date, a data currency adjustment is applied to account for wage growth in the intervening period.

The adjustment uses the Bureau of Labor Statistics Employment Cost Index (ECI), specifically the 12-month percent change for wages and salaries, private industry workers (BLS Series CIU2020000000000I, not seasonally adjusted). The ECI measures actual changes in employer labor costs and is widely used to project wage survey data forward.

This methodology is described by the Bureau of Labor Statistics in “Aging Wage Survey Data Using the Employment Cost Index” (Compensation and Working Conditions) and is a widely used approach in compensation analysis.

This tool implements all three valuation approaches described in the IRS Job Aid: Cost, Market, and Income. The Income Approach (Independent Investor Test) is available exclusively for professional accounts and considers the company’s financial performance via Fair Market Value data (see Section 05).

The following — four items from IRS Fact Sheet FS-2008-25’s nine-factor list that the tool does not directly compute, together with two related considerations outside that list — fall outside the tool’s scope and should be evaluated by the owner’s tax professional: