Year-End S-Corp Reasonable Compensation for CPAs

Part of WageProof's complete guide to S-corp reasonable compensation.

An S corporation gives its owner two ways to take money out of the business. One is a salary, paid through payroll like any employee's wages. The other is a distribution, which is a share of the profit. The two are taxed differently. Salary carries Social Security and Medicare taxes, 15.3% in total on most salaries, and distributions don't.

If that were the whole story, every owner would pay themselves almost nothing and take the rest as distributions. So the IRS requires an owner who works in the business to be paid a reasonable salary first. "Reasonable" means roughly what the business would have to pay someone else to do the same work in the same area. Tax professionals call this reasonable compensation.

Timing is where businesses get caught. Payroll taxes go by the date wages are paid, so work done in December but paid in January counts as January pay. An owner's salary for 2026 has to be paid by the last payroll of 2026. Once the year is over, fixing a salary that was too low means amending the year's payroll tax returns and filing a corrected W-2 (Form W-2c) for the owner.

That makes November the month for a CPA firm to check each S-corp client's salary. This guide covers which clients to check, what a written salary study should contain, how to pay a catch-up through payroll, and what happens when the IRS decides a salary was too low.

The short version

• An S-corp owner who works in the business has to be paid a reasonable salary before taking profit as distributions.
• Salary counts in the year it is paid. Pay for 2026 has to go out by the last payroll of 2026.
• A short written study, dated before that payroll, shows how the salary was set and what the business knew at the time.
• If the IRS decides the salary was too low, the business owes the missing Social Security and Medicare tax plus interest. Penalties may apply, depending on the facts.
• A business that gave a qualified adviser complete and accurate information, and relied on the adviser's advice in good faith, may be able to avoid penalties.

Why the salary has to be settled in December

Under the payroll tax rules, wages are received on the day they are paid (Treas. Reg. §31.3121(a)-2). Pay that goes out on December 15 is 2026 pay. Pay that goes out on January 15 is 2027 pay, even if the pay stub calls it a "2026 bonus."

Recording a bonus as owed on December 31 and paying it in January doesn't solve the problem either. A business can't deduct pay it owes a shareholder until the shareholder receives it (IRC §267), and this rule covers anyone who owns any of the S corporation's stock.

The year-end paperwork then reports whatever payroll paid:

• By February 1, 2027, the business gives each employee a W-2, the yearly statement of wages and taxes withheld. It also files Form 941 for the fourth quarter, the quarterly payroll tax return. Both are normally due January 31, which falls on a Sunday in 2027 (Publication 15).
• By March 15, 2027, it files Form 1120-S, the S corporation's tax return. Line 7 reports what the officers were paid. The IRS instructions for that line begin with a warning that payments to an officer "must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation" (Instructions for Form 1120-S).

There is one more reason to do the work before the last payroll. If the IRS ever questions the salary, a study dated in November shows what the business knew when it set the pay, and a study written after an IRS letter arrives can't. The income tax regulation on deducting pay judges it by the circumstances "existing at the date when the contract for services was made" (Treas. Reg. §1.162-7(b)(3)). No payroll tax rule says the same thing, but the same logic is a good reason to do the work early.

Which clients to check first

Put a client on the list if any of these describe them.

• The owner takes no salary at all. A Treasury Inspector General report found that 49.5% of S corporations report no officer compensation (TIGTA Report 2021-30-042).
• The salary is small and the distributions are large. In a 2012 case, an accountant's S corporation paid him a $24,000 salary and, after expenses, paid out the rest of what his accounting work earned as dividends. The courts set his reasonable salary at $91,044 (David E. Watson, P.C. v. United States).
• The salary was set by a percentage rule. Some owners pay themselves 60% of profit as salary and take 40% as distributions. No tax law sets a percentage. The IRS fact sheet on the subject says "there are no specific guidelines for reasonable compensation in the Code or the Regulations" (FS-2008-25). The 60/40 Rule Is a Myth covers the split in more detail.
• The owner's job changed. An owner who hired staff this year and now spends the week selling and managing is doing different work from the work the salary was set for.
• This is the first full year as an S corporation. The salary chosen when payroll was set up may never have been compared with what the market pays.
• Total receipts are $500,000 or more. The tax return then includes Form 1125-E, which lists each officer's pay next to the share of time that officer gives the business.
• Two or more owners are paid the same. If they do different work, the market would pay them differently.

What a reasonable compensation study should record

A reasonable compensation study is a written record of how the owner's salary was chosen. It can be a few pages long, as long as it shows how the number was reached.

The IRS publishes a guide on this topic for its own valuation staff, the Reasonable Compensation Job Aid. Every page of it says it is not an official IRS position. It is still a good picture of what an IRS reviewer looks for. It says a business "should keep records indicating the duties performed by its employees and the hours those employees worked," and it asks whether salary surveys or comparable pay figures were used.

A study that answers those questions covers four things.

1. What the owner does, and how the week divides. For example, half the week on client projects, a quarter on sales, and the rest on hiring and bookkeeping.
2. The method. There are three standard ones. The market approach compares the owner's pay with what similar businesses pay people in similar roles. The Job Aid calls it "the most commonly used method." The cost approach prices each part of the owner's job at the going wage for that kind of work, then adds the parts together. The income approach works from the company's financial results. Cost vs. Market Approach compares the first two.
3. The data. Name the wage source, the year of the data, the geographic area and the experience level. Courts look at these details. In a 2013 Tax Court case, the court started from state wage data produced with the Bureau of Labor Statistics, then adjusted it for the owner's limited experience and the company's modest operations (Sean McAlary Ltd., Inc. v. Commissioner).
4. How and when the number was approved. Minutes that simply approve a salary don't show how the number was reached. Watson's corporation approved his $24,000 salary at a shareholder meeting every year, and the appeals court still noted that "there were no documents reflecting these salary discussions." A dated written approval that names the study closes that gap. The study is what gives the approval weight. In McAlary, the court discounted a pay agreement the owner had made with his own company, partly because he "sat on both sides of the table."

The IRS fact sheet also lists nine factors courts weigh, and a complete file touches each one:

• the owner's training and experience;
• duties and responsibilities;
• time and effort devoted to the business;
• dividend history;
• what employees who aren't owners are paid;
• the timing and manner of bonuses to key people;
• what comparable businesses pay for similar work;
• any pay agreements;
• whether a formula was used to set pay.

The Nine IRS Factors takes them one at a time.

A calendar from November to March

These dates assume the client's last payroll of the year runs in mid-December. For a client paid monthly, start a week or two earlier. EA practices and other tax professionals who handle payroll for S-corp clients can use the same schedule.

• Early November. List every S-corp client and flag the ones that match the list above. For the file: the flag and the reason.
• Mid-November. Send each flagged client a short questionnaire about their duties and hours. For the file: the client's answers, dated.
• Late November. Run the study. For the file: the method, data source and year, area, experience level, and the resulting salary.
• Early December. Go over the result with the client and record the approval. For the file: a signed approval that names the study.
• Before the last payroll. Pay any shortfall through payroll. For the file: the payroll register.
• February 1, 2027. File the W-2s and the fourth-quarter Form 941. For the file: copies.
• March 15, 2027. File Form 1120-S and check line 7 (and Form 1125-E, if required) against the officers' W-2s, explaining any difference. For the file: the return and the reconciliation.

Example: one client's review

A designer has run her interior design business as an S corporation for two years. When she set up payroll, she picked a round number for her salary, and she has taken a distribution every month on top of it. This year she hired a junior designer, and her own week moved away from drawing plans toward sales calls and managing projects. Her distributions went up. Her salary stayed where it was, and nothing in the file explains how it was picked.

Her CPA puts her on the list in early November because her salary stayed flat while her distributions rose and her job changed. Her questionnaire shows about half her time on project management and client work, a quarter on sales, and the rest split between design and administration. The study prices each of those kinds of work at the going wage for her area and experience level. The total comes out higher than what payroll has paid her through November.

The firm adds the difference to her December 15 paycheck as a separately listed bonus. She signs a short written approval of the new salary that names the study. The firm saves the study, her questionnaire answers and the email in which it recommended the change.

Paying a catch-up through payroll

A catch-up is wages, so it goes through payroll with taxes withheld like any other paycheck.

Income tax withholding depends on the owner's payroll history. If income tax was withheld from the owner's regular salary this year or last year, a bonus paid separately, or listed separately on the paycheck, can be withheld at a flat 22% (37% on bonuses above $1 million in a year) (Publication 15). An owner who had no salary this year or last doesn't qualify for the flat rate. The bonus is then added to that period's regular wages and withheld as if it were one paycheck.

Social Security, Medicare and federal unemployment (FUTA) taxes apply to the bonus as well. The business deposits the Social Security and Medicare taxes, along with the income tax withheld, on its normal schedule. The exception is a deposit period where those taxes reach $100,000 on any day, which makes them due the next business day. FUTA tax has its own quarterly deposit schedule.

Health insurance for owners

If the S corporation pays health insurance for an owner who holds more than 2% of the stock at any time during the year (counting stock owned by close family members), the premiums go on that owner's W-2 as wages in box 1. When the coverage is part of a plan for all employees or a group of them, the premiums aren't subject to Social Security, Medicare or FUTA tax, so they stay out of boxes 3 and 5 (IRS guidance on S corporation medical insurance). The Form 1120-S instructions also call for them in box 14.

The owner may be able to deduct those premiums on their personal return, within limits. The coverage has to be set up by the S corporation; a policy in the owner's own name counts if the corporation paid or reimbursed the premiums and reported them on the W-2. The deduction can't be more than the salary the S corporation paid the owner, so an owner with no salary gets no deduction. It also isn't allowed for any month in which the owner or the owner's spouse was eligible for an employer-subsidized health plan (IRC §162(l)).

The salary has to actually be paid

In McAlary, the company had a pay agreement with its owner, but the court found no evidence that it ever paid him under it. That suggested, in the court's words, "that it was forgotten, ignored, or adopted as mere window dressing."

What happens if the IRS decides the salary was too low

The IRS can treat part of the owner's distributions as wages. The courts have backed that up. In Watson, the appeals court said that while reasonable compensation is usually an income tax question, "the IRS finds the concept equally applicable to FICA tax cases." (FICA is the Social Security and Medicare tax.)

Once distributions are treated as wages, the business owes the Social Security and Medicare tax that should have been paid on them. That includes the employee's half, which the business was required to withhold (IRC §3102(b)). It also owes interest (IRC §6601).

Penalties depend on the facts. In two 2013 Tax Court cases, Glass Blocks Unlimited and McAlary, the court upheld penalties for failing to file payroll tax returns (§6651(a)(1)) and for failing to deposit payroll taxes (§6656).

There is also a possible 20% accuracy-related penalty under IRC §6662, which is not automatic. On payroll tax, the part of that section that can apply is the one for negligence or disregard of the rules. The "substantial understatement" part covers income tax only. The penalty applies only where a return was filed, and it doesn't apply when the business shows reasonable cause and good faith (§6664). The IRS's manual for employment tax examiners counts a failure to "keep adequate books and records" as negligence (IRM 4.23.9.7).

The IRS generally has three years from April 15 of the year after the payroll returns cover (or from when they were filed, if later) to assess back payroll tax, and no time limit if they were never filed (IRC §6501). What happens when the IRS challenges an S-corp salary walks through an examination step by step.

How the paper trail can help the client

When a penalty is on the table, the usual defense is reasonable cause, meaning the business acted carefully and in good faith. Relying on a tax adviser can count. Courts check three things, using a test from a 2000 Tax Court case, Neonatology Associates:

1. The adviser was a competent professional with enough expertise to justify relying on them.
2. The business gave the adviser the necessary information, and the information was accurate.
3. The business actually relied on the adviser's judgment, in good faith.

McAlary's company lost on this point. It offered no evidence that it had checked its adviser's qualifications, and the penalties stood. McAlary is a summary opinion, so it isn't treated as precedent for other cases, but it shows how courts apply the test.

The Supreme Court has drawn a line here. In United States v. Boyle (1985), it held that relying on someone else to file a return on time isn't reasonable cause. Relying on an accountant's advice about a question of tax law can be.

A 2023 appeals case shows the defense working. In Clary Hood, Inc. v. Commissioner, a company was penalized over its CEO's bonuses. The Fourth Circuit threw out the penalty because the company had "discussed that plan with its tax advisors at Elliott Davis, who approved it as reasonable." The case was about a C corporation's income tax, so it says nothing directly about payroll tax. Its reasoning about relying on advisers is what carries over.

For the CPA firm, all of this comes down to keeping its side of the record. That means the study, the client's answers about duties and hours, and the firm's recommendation in writing, whether in an email or the engagement letter.

Where WageProof fits

WageProof is software that produces this study. Cost and market approach reports use Bureau of Labor Statistics wage data, and income approach reports use the business's value at the start of the year and how much that value grew. Every cost or market approach report shows the occupations, BLS data year, area and experience level behind its figure, which covers the data the file needs. A firm can send the client the duties-and-hours questionnaire or fill it in from its own notes, and the Professional and Firm plans put the firm's branding on the report.

The sample report is a finished example, and the methodology page explains the calculations. WageProof for CPAs and EAs covers how firms use it.