The 9 IRS Factors for Reasonable Compensation, Explained

The IRS uses nine factors to evaluate whether an S-corp owner's salary is reasonable. They come from IRS Fact Sheet 2008-25, published in 2008, and they're still the primary framework that IRS examiners and Tax Court judges use today. If you're setting your own salary or advising a client, every one of these factors should be addressed in your documentation.

Key Takeaways

• The IRS evaluates reasonable compensation using nine factors from Fact Sheet 2008-25, plus additional factors developed through court decisions.
• No single factor is determinative. The IRS looks at the totality of circumstances.
• The most important factors in practice: duties performed, comparable salaries, and training/experience.
• A strong report should address each factor with specific evidence, not just list them as references.
• Factor #9, "the use of a formula," is a negative factor. Percentage-based rules of thumb work against you.

Where the nine factors come from

IRS Fact Sheet 2008-25, titled "Wage Compensation for S Corporation Officers," lays out "some factors considered by the courts in determining reasonable compensation." The word "some" is important. The IRS is deliberately non-exhaustive. Courts have developed additional factor tests over the years, including the LabelGraphics 5-factor test and the Brewer Quality Homes 10-factor test.

But FS-2008-25 remains the primary reference. It's what IRS examiners are trained on, and it's what Tax Court opinions cite most frequently. If your reasonable compensation documentation addresses all nine of these factors, you're covering the framework the IRS expects to see.

The nine factors

1. Training and experience

What the IRS looks at: Your education, professional certifications, specialized training, and years of experience in your field. A CPA with 20 years of practice commands different compensation than someone who just passed the exam. An electrician with a master's license is valued differently than an apprentice.

How to document it: State your relevant degrees, certifications, licenses, and years of industry experience. Be specific. "15 years of experience in commercial real estate development" is stronger than "experienced business owner."

Why it matters: This factor establishes the baseline for what your labor is worth in the market. More training and experience generally justifies higher compensation.

2. Duties and responsibilities

What the IRS looks at: What you actually do in the business. Not your title, not your aspirations. The specific tasks you perform on a regular basis. Are you doing bookkeeping? Managing employees? Selling? Consulting with clients? Sweeping the floor?

How to document it: List your duties with enough specificity that someone outside the business could understand your role. The more granular, the better. "General management" is weak. "Managing a team of 4 employees, handling client acquisition, overseeing project delivery, and managing accounts receivable" is strong.

Why it matters: This is one of the two most important factors in practice. The IRS wants to match what you do to what the market pays for that work. Most S-corp owners wear many hats, which is exactly why the Cost Approach (which prices each task independently) is useful. See Cost Approach vs. Market Approach for more on how this works.

3. Time and effort devoted to the business

What the IRS looks at: How many hours per week you work in the business. Full-time? Part-time? Seasonal?

How to document it: State your typical weekly hours. If it varies by season or project cycle, explain that. An owner working 50 hours a week has a different compensation profile than one working 15.

Why it matters: Time is a multiplier. The same hourly value applied over different hours produces different annual compensation. Courts have used the 2,080-hour standard (40 hours x 52 weeks) as a full-time baseline, following McAlary v. Commissioner. If you work fewer hours, your compensation should be proportionally lower. If you work more, the additional hours above 2,080 don't typically increase the figure because the standard caps at full-time equivalent.

4. Dividend history

What the IRS looks at: Your pattern of salary versus distributions over time. This is the red flag factor. If you've been taking $200,000 in distributions and paying yourself $30,000 in salary for years, that pattern tells the IRS your salary probably isn't reflecting the real value of your work.

How to document it: Be honest about your distribution history. If the ratio looks aggressive, acknowledge that and explain what's changed (new analysis, better documentation, adjusted salary based on market data). The worst thing you can do is ignore this factor when your numbers tell an obvious story.

Why it matters: Large distributions paired with a small salary is the most common trigger for an IRS challenge. In Watson v. Commissioner, the court looked at distributions exceeding $200,000 against a $24,000 salary and found it plainly unreasonable. Your documentation should show that your salary reflects the market, independent of how much you're distributing.

5. Payments to non-shareholder employees

What the IRS looks at: What you pay other employees who do similar work. If you have a non-owner operations manager making $90,000 and you're paying yourself $40,000 while performing the same duties plus more, that's hard to justify.

How to document it: If you have employees performing comparable work, note their compensation. If you don't have employees (many S-corps are solo operations), this factor is less relevant, but you should say so explicitly rather than leaving it unaddressed.

Why it matters: Internal comparables are strong evidence. They're harder for the IRS to dispute than external market data because they reflect what your specific business actually pays for the work.

6. Timing and manner of paying bonuses

What the IRS looks at: Whether bonuses to shareholder-employees correlate with performance, or whether they look like disguised distributions. A year-end bonus that conveniently brings total compensation to a round number right before large distributions raises questions.

How to document it: If you pay yourself bonuses, document the basis for them (profitability milestones, project completion, annual performance review). If you don't pay bonuses, say so.

Why it matters: Irregular or suspiciously timed bonus payments can undermine an otherwise reasonable salary structure. Consistency and documentation matter here.

7. What comparable businesses pay for similar services

What the IRS looks at: Market data. What would you have to pay someone with your skills to do your job in your geographic area? This is the heart of any reasonable compensation analysis.

How to document it: Cite specific data sources. The Bureau of Labor Statistics Occupational Employment and Wage Statistics (OES) program is the gold standard. It's publicly available, it's what the IRS uses in its own analyses, and it covers 800+ occupations across 400+ metro areas. Your documentation should make the occupation codes, geographic area, data year, and experience-level adjustments traceable so an IRS examiner can follow the path from your duties to your salary number.

Why it matters: This is the other most important factor alongside duties performed. Courts have consistently ruled that data-backed analysis from recognized sources beats self-serving testimony. In Clary Hood v. Commissioner (2023), the court rejected the taxpayer's expert because the comparable data didn't match the actual business. The IRS expert's more transparent, industry-specific analysis won.

8. Compensation agreements

What the IRS looks at: Whether there's a formal written agreement or board resolution documenting the compensation decision. Did the board (even if it's just you) formally approve the salary based on a documented analysis?

How to document it: Pass a board resolution that sets the salary amount, references the market data or analysis used, and gets filed with your corporate minutes. This takes 10 minutes and dramatically strengthens your position. Many reasonable compensation reports include template resolution language for exactly this purpose.

Why it matters: Contemporaneous documentation is much stronger than an analysis produced after the IRS starts asking questions. A board resolution shows you thought about this proactively.

9. The use of a formula to determine compensation

What the IRS looks at: Whether you used an arbitrary formula or percentage to set your salary. And this is a negative factor. If you set your salary as "60% of net income" or "50% of distributions," you're actually making the IRS's case easier.

How to document it: Don't use a formula. The IRS and Tax Court have explicitly rejected percentage-based approaches. Your salary should be based on market data for your specific role, area, and experience, not on a ratio of revenue or profit. If someone tells you the "60/40 rule" is an accepted methodology, they're wrong.

Why it matters: This factor exists specifically because the IRS knows that formula-based approaches are often used to justify artificially low salaries. A consulting firm at $500,000 in revenue and a trucking company at $500,000 in revenue have completely different salary profiles for their owner-operators. A percentage formula treats them identically, which is exactly the kind of lazy analysis the IRS rejects.

Which factors matter most in practice

In Tax Court cases, three factors tend to drive outcomes:

Comparable salaries (#7) is almost always the deciding factor. If you have solid market data showing what your role pays in your area, and your salary falls within that range, you're in a strong position. If you don't have data, you're relying on the IRS examiner's analysis instead of your own.

Duties and responsibilities (#2) determine which market data applies. The IRS doesn't just ask "are you a business owner?" They ask "what do you actually do all day?" An owner who spends 40% of their time on bookkeeping, 30% on sales, and 30% on client delivery has a different market value than one who spends 100% of their time on high-level consulting.

Dividend history (#4) is the trigger factor. It's rarely the basis for setting the correct number, but an extreme salary-to-distribution ratio is often what puts you on the IRS's radar in the first place.

How a reasonable compensation report addresses the factors

A well-built report doesn't just calculate a number. It works through the factors:

• It documents your duties by asking you to select and describe your tasks (factors 2 and 3).
• It matches those tasks to BLS wage data for your metro area and experience level (factor 7).
• It adjusts for your training and qualifications through proficiency ratings tied to measurable criteria like years of experience (factor 1).
• It produces a documented methodology with source citations, not a formula-driven output (factor 9).
• It includes board resolution language for your corporate records (factor 8).

The remaining factors (4, 5, 6) are business-specific context that should be reviewed with your CPA. A good report gives your CPA the data foundation; they bring the tax planning context.

WageProof's report is built around this framework. You can see exactly how it addresses these factors in the sample report, and the full methodology is published on our methodology page.