How the wage and distribution split inside an S corporation works, what makes an owner's salary defensible against market data, and the three cases where the number, the payroll, or the paperwork failed.
By Samuel Ortiz, CPA, CVA · Last updated August 23, 2026
An S corporation owner who works in the business must take reasonable wages, meaning pay in line with what the market offers for the same work, before taking profit distributions. Distributions avoid Social Security and Medicare tax, which is the advantage, but the salary underneath them cannot be set artificially low, and it holds up only when it is supported by market data, set at arm's length, and actually run through payroll with a W-2 behind it.
An S corporation files a return but generally pays no tax itself, its profit passes through to the owners, and an owner who works in the business wears two hats on the way to being paid. What arrives as wages bears Social Security and Medicare tax like any paycheck in the country, and what arrives as profit distributions above those wages does not, which is the entire attraction of the structure and a completely legitimate one, recognized in the law for decades and questioned by no court in any of the cases below.
What the IRS has refused to accept, in a position it has held since the 1970s, is a salary set low for no reason other than shrinking the payroll tax base. Reasonable compensation means the number an unrelated employer would pay for the same services, judged from the outside: the role actually performed, the hours actually worked, the training and experience behind them, what the business earns from that work, and what comparable businesses pay comparable people. It is a market question, answered with market evidence, which is why the government brings valuation experts to these cases and why the file behind an owner’s salary should hold the same kind of data, gathered when the number was set rather than after a notice arrives.
The number also has to be real in the mechanical sense, wages on a W-2, payroll actually run, employment returns actually filed, because a salary that exists only as a line in the minutes has never paid anyone anything. Distributions remain fully available on top, that part of the strategy survives every opinion on this page, and the only question a court ends up asking is whether the salary underneath them was a number the record could carry.
$24,000 a year. That is the salary David Watson, a CPA with a master’s degree in taxation and nearly twenty years of experience, took from the S corporation through which he ran his interest in a successful Iowa accounting firm, and over the same two years, 2002 and 2003, the company passed him more than $200,000 in one year and $175,000 in the next as profit distributions, which carried no payroll tax. The arrangement was not subtle. A seasoned accountant working full time at a firm bringing in several hundred thousand dollars was reporting the salary of an entry level bookkeeper, while the bulk of his compensation arrived under a label that happened to skip Social Security and Medicare.
The government did not accept the label. Its expert valued Watson’s actual services at $91,000 a year, built from what comparable firms paid for comparable work, and both the district court and the Eighth Circuit agreed, recharacterizing the shortfall as wages and handing the company the bill for the unpaid employment tax, penalties, and interest. The holding is the whole strategy in one sentence: in an S corporation the label on a payment does not decide how it is taxed, the substance of the work does, and owners are entitled to distributions only after paying themselves a reasonable salary for the work they actually perform. A figure that looks engineered to sidestep payroll tax invites exactly the scrutiny Watson drew.
Watson is the case where the salary was too low. The two cases that followed it complete the set, and each one fails at a different link in the same chain.
Sean McAlary ran a one man real estate brokerage through an S corporation, and his board minutes from 2004 authorized a salary of $24,000, which is where the resemblance to a salary ended, because no W-2 was ever filed and no payroll was ever run while he drew $240,000 against $231,454 of net income. The Tax Court, in a summary opinion that cannot be cited as precedent and is no less instructive for it, called the minutes “mere window dressing,” reset his compensation to $83,200, forty dollars an hour across a 2,080 hour working year, and sustained the Social Security, Medicare, and unemployment tax bills along with penalties for the employment tax returns that were never filed. A number in the minutes is not a number on a payroll.
Ryan Fleischer, a financial advisor in Nebraska, incorporated Fleischer Wealth Plan, elected S status, and paid himself a salary of $34,851 while running his commissions from LPL and MassMutual through the corporation, and none of it held, because the representative agreement had been signed in his personal name five days before the corporation existed, the 1099s named him individually, and no agreement required him to turn the commissions over to the entity. The Tax Court applied the two part test from its Johnson line of cases, asking who controlled the earning of the income and whether the paying companies recognized the corporation at all, and moved every dollar back to his Schedule C with self employment tax for all three years at issue, a difference of $41,563. The structure only works when the contracts, the counterparties, and the 1099s actually name the entity.
Read together the three cases are one rule written three times. A salary set too low will be reset against market data, a salary that exists only in the minutes was never paid at all, and income that never legally reached the corporation cannot be split in the first place. The strategy itself walks out of all three opinions untouched, wages first at a defensible number, distributions after, everything named, papered, and run through payroll, and the only taxpayers who lost were the ones whose records could not carry the position.
Ideas do not change your tax number, implementation does, and implementation is books kept current, records made at the time rather than reconstructed later, elections filed on time, and every position reported the way the return will one day have to defend it. That is the year round work a strategy actually requires, and on the strategies we implement we stand behind that work with audit defense. Reading about a strategy is step zero. The record is what decides whether it holds.
It means wages in line with what an unrelated employer would pay for the same services. The measure looks at the role actually performed, the time it takes, the training and experience behind it, what the business earns from that work, and what comparable businesses pay comparable people for comparable duties.
With market evidence. In examinations and in court the government uses valuation data and expert testimony about what the same services command in the open market, which is how the expert in the Watson case arrived at $91,000 a year for a CPA whose company was paying him $24,000. An owner setting a salary is expected to be able to point to the same kind of data.
The IRS can recharacterize distributions as wages up to a reasonable amount, and the corporation then owes the unpaid Social Security and Medicare taxes along with penalties and interest. The courts have sustained this repeatedly, including at the appellate level in Watson.
No. In the McAlary case the corporate minutes authorized a salary of $24,000, but no W-2 was filed and no payroll was run, and the Tax Court treated the minutes as decoration rather than compensation and set the owner's wages at $83,200 based on market data. A salary exists when it is paid and reported, not when it is written down.
Wages are employment income, so they bear Social Security and Medicare taxes and appear on a W-2. Distributions of S corporation profit are not wages and carry no payroll tax, which is the legitimate advantage of the structure and also the reason the IRS looks closely at any salary that seems engineered to keep the wage number small.
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