Are You Paying Yourself Enough? What “Reasonable Compensation” Really Means for Law Firm Owners
If your firm is taxed as an S-corporation, you already know the basic structure: pay yourself a salary, then take the rest of the firm’s profit as a distribution. The distribution isn’t subject to payroll tax. The salary is. That difference is exactly why the IRS has a rule for it – and why “reasonable compensation” is one of the most quietly consequential numbers on your firm’s books.
This isn’t a theoretical concern. It’s the subject of a standing IRS enforcement priority, a body of case law going back more than a decade, and a conversation that belongs alongside the business structure decisions covered in our post on strategic tax planning – not after an audit notice arrives.
Key Takeaways
- S-corp shareholder-employees must be paid a “reasonable” W-2 salary before taking the rest of their income as distributions – distributions alone, without a defensible salary, are a known audit trigger.
- There is no official formula or safe-harbor percentage. The IRS and the courts apply a facts-and-circumstances test built on training, duties, time devoted, and comparable market pay.
- The landmark case, involving a CPA who paid himself $24,000 against $379,000 in dividends, ended with the court setting his reasonable salary at $91,044 – and reclassifying the difference as wages subject to payroll tax.
- Round numbers, static salaries, and a salary that never changes while distributions climb are all documented red flags.
- The 2026 Social Security wage base is $184,500, with combined Social Security and Medicare tax (FICA) running 15.3% on self-employment income – the exact savings underpaying is designed to capture, and exactly what the IRS is positioned to claw back.
- Because W-2 wages are excluded from qualified business income, this number now intersects directly with the permanent Section 199A deduction – raising the stakes on getting it right in both directions, not just the low one.
Why the IRS Cares About This Specific Number
The IRS states its standard plainly: a shareholder-employee of an S-corporation must be paid “reasonable compensation” – generally understood as what an arm’s-length employer would pay someone else to perform the same duties – before any additional profit is distributed. Distributions are not subject to Social Security or Medicare tax. Salary is. Every dollar shifted from salary to distribution is a dollar that avoids the 15.3% self-employment tax that would otherwise apply.
That incentive is precisely why this is an enforcement priority rather than a technicality. A firm owner who pays themselves a token salary and takes six figures in distributions isn’t quietly optimizing – they’re taking a position the IRS has specifically trained its examiners to look for.
The Case Every Advisor Points To
The most cited case on this issue involves David Watson, a CPA and the sole shareholder of his accounting firm’s S-corporation. Over two years, his firm paid him a salary of $24,000 while distributing more than $379,000 to him as dividends. The IRS’s expert witness calculated what an arm’s-length employer would have paid someone with Watson’s roughly 20 years of experience, working 35 to 45 hours a week as the firm’s primary revenue producer. The court agreed: reasonable compensation was $91,044 – nearly four times what he’d actually been paid – and the difference was reclassified as wages, triggering back payroll taxes, penalties, and interest.
Watson was a CPA, not an attorney, but the case has become the baseline every subsequent reasonable-compensation dispute gets measured against, across every licensed professional-services S-corp – law firms included.
How the Number Actually Gets Set
There’s no IRS worksheet that spits out a dollar figure. Courts and examiners weigh a set of factors, none of which is controlling on its own:
- Training, licensure, and years of experience in the role
- The actual duties performed – not a job title, but what the owner does day to day
- Time and effort devoted to the business, including non-billable work like management, business development, and mentoring
- What comparable employers pay for similar work, drawn from recognized wage data rather than casual job-board averages
- The firm’s distribution history – a pattern of large, growing distributions against a flat salary draws more scrutiny, not less
- Whether a compensation decision was documented in advance, rather than reverse-engineered at tax time
A frequently repeated shortcut – paying roughly 60% of profit as salary and 40% as distribution – is not an IRS-sanctioned safe harbor. Courts have specifically rejected formula-based approaches as a substitute for the facts-and-circumstances analysis above. Treating it as a rule is itself a red flag.
The Patterns That Invite a Closer Look
A few signals consistently appear in cases the IRS pursues: a round-number salary that was clearly chosen rather than calculated; a salary that stays flat for years while firm revenue and distributions grow; a shareholder-employee who takes a full distribution while claiming to work only part time; and a $0 salary paired with substantial distributions, which courts have treated as close to indefensible when the owner is actively performing services. None of these require intent to deceive – they simply make a firm easier to flag and harder to defend once flagged.
Why This Matters More Now, Not Less
The Section 199A qualified business income deduction – made permanent for pass-through businesses under last year’s tax law – specifically excludes W-2 wages from the income it’s calculated against. That creates a real tension: minimizing salary can appear to preserve more income eligible for the 20% QBI deduction, while the IRS’s reasonable compensation standard requires exactly the opposite when a lower salary doesn’t reflect the actual value of the work performed.
The firms that navigate this well aren’t the ones who pick a side. They’re the ones who treat compensation and QBI eligibility as one connected decision, reviewed together, rather than two separate numbers chosen in isolation.
This Is a CFO-Level Decision, Not a Once-a-Year Guess
Setting a defensible number takes more than a single calculation. It takes a documented role description, a comparison to real market data for the work actually performed, and – ideally – a written determination made before the year begins, not reconstructed after an IRS letter arrives. It also depends on clean, current books that can actually show what the firm paid, when, and against what revenue – documentation that’s far easier to produce proactively than to assemble under audit.
This is exactly the kind of decision CFO advisory work is built for: not a single tax-season calculation, but an ongoing read on how compensation, distributions, entity structure, and deductions all move together as the firm’s numbers change.
Frequent Asked Questions (FAQs)
What counts as "reasonable compensation" for an S-corp law firm owner?
Generally, what an arm’s-length employer would pay someone else to perform the same duties, given the owner’s training, experience, and the time actually devoted to the role. There’s no fixed percentage or dollar figure – it’s a facts-and-circumstances determination.
Is the 60/40 salary-to-distribution split a safe rule to follow?
No. It’s a commonly repeated shortcut, not an IRS-approved standard. Courts have specifically declined to treat a fixed formula as a substitute for evaluating the actual role, duties, and comparable pay.
What happens if the IRS decides a salary was too low?
The difference between what was paid and what’s deemed reasonable can be reclassified as wages, triggering back payroll taxes on that amount, plus penalties and interest – as happened in the case outlined above.
Does this apply to every law firm owner?
It applies specifically to shareholder-employees of S-corporations (or entities electing S-corp tax treatment) who also perform services for the firm. Owners under other structures face different rules, which is a reason entity structure itself is worth revisiting periodically.
How does this connect to the QBI deduction?
W-2 wages are excluded from qualified business income, so a lower salary can appear to preserve more income eligible for the Section 199A deduction. That doesn’t change the reasonable compensation requirement – it just means the two numbers need to be set together, not independently.
How Silver Peaks CPA Can Help
Reasonable compensation isn’t a box to check once a year – it’s a number that should hold up to scrutiny because it was set deliberately, not because it’s never been questioned. Our strategic tax planning and CFO advisory work for law firms builds that determination into the same review as entity structure, distributions, and deductions, so the number on your W-2 is one you could defend, not just one you’ve always used.
Any other questions, feel free to schedule an informed opinion on where your firm stands.
