S-Corp Reasonable Compensation: The 25K/220K Story That Cost a CPA His License

A tax pro on r/taxpros shared a story I haven't been able to forget:

"I literally just took a NATP course about S Corps. The instructor shared a story… the owner who was the top CPA only gave himself a salary of 25k. Then a bonus for 220k. Long story short, the CPA lost the license and practice because the IRS got the guy, he sued the CPA…"

The story is extreme. It's also instructive about exactly why S-corp reasonable compensation is the IRS's favorite small business audit trigger — and why the savings can quickly become liability if you push too hard.

This post is the framework that keeps you on the right side of the line.

How S-corp tax savings actually work

Quick refresher: an S-corp is a tax election (not a legal entity) that allows business income to flow through to the owner without paying federal corporate income tax. Critically, S-corp distributions are not subject to self-employment tax (15.3%).

So the optimization play:

• LLC or corporation files Form 2553 to elect S-corp status
• Owner pays themselves a "reasonable salary" (W-2, subject to FICA)
• Remaining business profit flows through as distributions (no FICA, no SE tax)

For an owner with $200K of net business income who pays themselves $80K salary:

• W-2 salary: $80K (subject to 7.65% employer + 7.65% employee FICA = 15.3% × $80K = $12,240)
• Distribution: $120K (no FICA, no SE tax)
• SE tax saved vs. all-distribution: 15.3% × $120K = $18,360

The temptation is obvious: if a $20K salary saves more SE tax than an $80K salary, why not pay yourself $20K?

The answer is the IRS, the audit guidelines, and case law.

What "reasonable compensation" actually means

The IRS rule is that S-corp shareholders who provide services to the corporation must receive reasonable compensation for those services before any distributions.

"Reasonable" means: what you would pay an employee with similar skills, experience, and responsibilities to do the same work.

The IRS Audit Manual Guideline lists the factors they consider:

1. Training and experience of the shareholder
2. Duties and responsibilities performed
3. Time and effort devoted to the business
4. Dividend history of the corporation
5. Payments to non-shareholder employees doing similar work
6. Timing and manner of paying bonuses to the shareholder
7. What comparable businesses pay for similar services
8. Compensation agreements in place
9. Use of formula to determine compensation

The factors create real flexibility. An IT consultant can defend a different salary than a hands-on contractor doing field work, even at similar revenue levels.

The 25K/220K problem

The Reddit story is extreme but instructive. A CPA — someone whose entire job is tax compliance — paying themselves $25K salary and taking $220K in distributions/bonuses.

Why this is a problem:

• A CPA earns $80-200K per year market salary
• $25K is what you'd pay a part-time bookkeeper, not a CPA
• Taking the rest as distributions saves SE tax on $195K (~$30K of tax)
• The IRS auditor sees this immediately and reclassifies distributions as wages

The reclassification triggers:

• Back FICA tax owed on the reclassified amount
• Penalties (typically 25% accuracy-related penalty)
• Interest from the original due date
• For preparer (the CPA): preparer penalties, ethics complaint, possible license revocation

In the Reddit version, the IRS reclassified the distributions, the owner owed back tax + penalties + interest, and then sued the CPA for malpractice. The CPA's career ended.

The defensible framework

For most service business owners, here's the defensible approach:

Step 1: Document the role

Write down what you actually do. Don't be modest. List:

• Sales activity
• Operations management
• Customer service
• Technical work
• Administration
• Strategic planning

This documentation matters. The IRS asks "what did you do?" and you need a written answer.

Step 2: Research market salary

For each role/responsibility, find the market salary using:

• BLS Occupational Employment Statistics
• Salary.com / Glassdoor / Payscale
• Industry-specific salary surveys (NRA for restaurants, AICPA for accountants, etc.)
• Recruiter quotes for similar positions

Add the salaries weighted by % of time spent on each function.

Step 3: Apply the "what would I pay an employee" test

If you weren't the owner, what would you pay an employee to do this exact job? That's your benchmark.

For a service business owner who:

• Sells (20% of time): Sales rep salary $60-90K → weighted contribution $12-18K
• Manages operations (30% of time): Ops manager salary $70-110K → weighted contribution $21-33K
• Does field work (30% of time): Senior tech salary $60-90K → weighted contribution $18-27K
• Handles admin (20% of time): Office manager $40-65K → weighted contribution $8-13K

Total weighted reasonable comp: $59-91K.

For most $1-3M service businesses, the reasonable comp range is $80-150K depending on owner skill and engagement.

Step 4: Set the salary at the higher end of the defensible range

Why higher end?

• The IRS won't object to higher salary (they collect more FICA)
• It builds in margin for audit
• It supports the "I'm doing market-rate work" narrative
• It justifies higher distributions later

If your defensible range is $80-120K, set salary at $100-120K. The "savings" of going lower aren't worth the audit exposure.

Step 5: Document everything

Keep:

• Job description
• Salary research (links, dates, sources)
• Board minutes or written compensation decision
• Time logs (rough, not down to the minute)
• Year-end salary review documentation

If audited, this packet is your defense.

Real-world salary benchmarks

For service business owners by trade and revenue level (rough guidance, depends heavily on geography and engagement):

These are starting points, not definitive. Customize based on your actual role, geography, and credentials.

The audit math: how often do they actually audit?

S-corp returns have a low audit rate (~0.4% as of recent IRS data), but the audit targeting for reasonable comp is much higher when the IRS computer flags:

• Owner salary < $25K with significant distributions
• Salary < 25% of distributions
• Salary that hasn't increased over multiple years despite revenue growth
• Loans to shareholders (often disguised distributions)
• No salary at all (most aggressive flag)

If you're in a flagged pattern, your effective audit risk is closer to 5-15% — not 0.4%.

What to do if you've been doing it wrong

If you've been an S-corp for years with an unreasonably low salary:

Option 1: Adjust going forward

Increase your salary to defensible levels starting this year. Document the reasoning. Don't try to retroactively fix prior years — that creates more questions than it answers.

Option 2: Voluntary correction

For severe cases (years of $0 or trivial salary), consider proactively reclassifying with your CPA. This requires:

• Amended W-2s for prior years
• Amended payroll tax filings (941, 940)
• Payment of FICA owed plus penalties
• Possibly amended 1040 if tax was incorrectly calculated

This is expensive but limits future audit exposure.

Option 3: Hope and adjust

If exposure is small and prior pattern was modestly aggressive, simply correct going forward and accept the audit risk. Most cases never get audited. Talk to a CPA before defaulting to this option.

When to call Level

S-corp setup, reasonable compensation, and tax planning aren't tax return preparation — but they're upstream of tax return preparation, and they need someone who understands both the business and the tax implications.

Level coordinates with CPAs/EAs to:

• Determine if S-corp election makes sense for your stage
• Set reasonable compensation with documented support
• Manage payroll for S-corp owner-operators
• Coordinate quarterly distributions and tax payments
• Audit-prep documentation

This work is usually 2-5 hours per quarter for most owner-operators, baked into broader CFO engagement.

FAQ

Can I just pay myself the FICA wage base ($168,600 for 2026) and take the rest as distribution? Yes — that's actually a defensible target for many owners. Once you exceed the FICA wage base, the marginal SE tax savings drop substantially (only the 2.9% Medicare portion still applies). Many S-corps target salary at or just above the FICA wage base.

What if I work part-time in the business? Reasonable comp scales with hours worked. A part-time owner doing 10 hours per week shouldn't pay a full-time market rate salary. Document the actual time and adjust accordingly.

What if my business has zero profit this year? You can take a lower salary (or zero) in unprofitable years — but the IRS expects profitable years to include reasonable compensation before any distributions. "I had a bad year" is a defensible reason for a year. "I always have a bad year" isn't.

Can I make up missed reasonable comp with a year-end bonus? Yes — many owners do exactly this, paying themselves a regular salary plus a year-end bonus once profit is known. The bonus must be paid by year-end (W-2 reportable) to count for that tax year.

Related reading:

• S-Corp vs LLC for Contractors
• How Much Should a Business Owner Pay Themselves?
• Tax Penalties for Small Businesses