Advisory Guidance for Owner-Employees in 2025

By Jessica I. Marschall, CPA

December 27, 2025

Reasonable compensation remains one of the most consistently examined and litigated issues affecting S corporations and entities electing S-Corporation treatment. Despite long-standing IRS guidance and extensive case law, underpayment of shareholder wages continues to be a primary driver of payroll tax adjustments, penalties, and protracted examinations.

As IRS enforcement resources remain focused on employment tax compliance, S corporations with disproportionate distributions relative to W-2 wages face elevated audit risk. This advisory outlines the legal foundation, judicial precedent, and practical compliance framework that CPA-advised clients should follow in 2025.

Statutory and Regulatory Foundation

Internal Revenue Code § 3121 defines “wages” for FICA purposes as all remuneration for employment. Treasury Regulations §§ 31.3121(a)-1(b) and 31.3121(d)-1(b) establish that corporate officers who perform more than minor services are employees, and that the form of payment is immaterial in determining whether payments constitute wages.

IRC § 1366(e) provides that when a family member of an S corporation shareholder renders services without receiving reasonable compensation, the Secretary may make appropriate adjustments to reflect the value of such services.

The IRS has authority under IRC § 7436 to reclassify distributions as wages where compensation is unreasonably low. This position has been repeatedly upheld by the courts and is not a recent or evolving interpretation.

Judicial Precedent Supporting IRS Enforcement

Courts have consistently ruled in favor of the IRS where shareholder-employees attempted to minimize payroll taxes by suppressing wages. Key cases include:

David E. Watson, P.C. v. United States

757 F. Supp. 2d 877 (S.D. Iowa 2010), aff’d, 668 F.3d 1008 (8th Cir. 2012)

A CPA who paid himself $24,000 annually while receiving distributions exceeding $175,000 had a portion of those distributions reclassified as wages. The court accepted the IRS expert’s determination that reasonable compensation was approximately $91,000. The Eighth Circuit affirmed, emphasizing that compensation must reflect the value of services actually performed and that taxpayer intent regarding the characterization of payments is not controlling.

Joseph Radtke, S.C. v. United States

895 F.2d 1196 (7th Cir. 1990)

One of the earliest and most cited cases in this area. An attorney who was the sole shareholder-employee paid himself zero salary while taking $18,225 in dividends. The Seventh Circuit held that these payments were clearly remuneration for services performed and therefore constituted wages subject to FICA and FUTA, establishing that payments to shareholder-employees for services are wages regardless of how they are labeled.

Spicer Accounting, Inc. v. United States

918 F.2d 90 (9th Cir. 1990)

The Ninth Circuit rejected the taxpayer’s attempt to avoid employment taxes by characterizing compensation as dividends. The court held that because Mr. Spicer performed substantial services essential to the accounting firm, payments to him should be deemed wages subject to FICA and FUTA, reinforcing that substance controls over form.

JD & Associates, Ltd. v. United States

No. 3:04-cv-59 (D.N.D. 2006)

The court found that paying minimal wages while distributing substantial profits was not defensible. The IRS hired a valuation expert who used Risk Management Association data to determine appropriate compensation for comparable accountants, and the IRS was permitted to impose payroll taxes on the reclassified amounts.

These cases collectively make clear that reasonable compensation is not elective, negotiable, or subject to aggressive tax positioning.

IRS Analytical Framework

The IRS does not apply a fixed formula. Instead, examinations rely on a facts-and-circumstances analysis that evaluates:

• The nature and scope of services performed
• Time devoted to the business
• Training, experience, and professional credentials
• Comparable compensation for similar roles and industries
• The company’s financial performance and growth
• Historical compensation patterns
• The shareholder’s control over pay decisions
• The relationship between wages and distributions

In practice, the IRS places substantial weight on economic reality and third-party comparables.

Common Audit Risk Indicators

From an advisory perspective, the following conditions materially increase exposure:

• Flat or nominal wages despite significant profit growth
• W-2 wages that represent a small fraction of total earnings
• Majority or sole shareholders actively managing operations
• High distributions coupled with minimal payroll tax liability
• Lack of documentation supporting compensation decisions

In active owner scenarios, wages below approximately 25 percent of net income frequently draw scrutiny unless well supported by objective evidence.

Practical Advisory Guidance for 2025

Based on current enforcement trends and judicial precedent, CPA-advised S corporations should expect reasonable compensation for active owners to generally fall within a 35 to 50 percent range of net income, adjusted for:

• Industry norms
• Revenue source (services versus capital)
• Level of delegation
• Business maturity

While not a safe harbor, compensation within this range is typically defensible when supported by contemporaneous documentation.

Consequences of Noncompliance

When wages are deemed unreasonable, the IRS may:

• Reclassify distributions as wages
• Assess employer and employee FICA taxes
• Impose failure-to-withhold penalties
• Apply accuracy-related penalties under IRC § 6662
• Accrue statutory interest

Proactive correction prior to examination often limits penalties and supports a reasonable cause defense.

Recommended Best Practices for CPA-Advised Clients

To mitigate risk, firms should counsel S corporation clients to:

1. Conduct Annual Compensation Reviews

Particularly when profitability changes materially.

• Document Shareholder Roles and Time Commitment

Including managerial, operational, and revenue-generating activities.

• Maintain Comparable Salary Support

Using BLS data, industry surveys, or third-party compensation studies.

• Formalize Decisions

Through board or shareholder meeting minutes.

• Align Wages and Distributions

To reflect the economic substance of the business.

Advisory Conclusion

Reasonable compensation is a compliance obligation grounded in statute, reinforced by decades of case law, and actively enforced by the IRS. S corporations that suppress wages in favor of distributions expose themselves to avoidable tax, penalty, and audit risk.

For CPA firms, proactive advisory around reasonable compensation is no longer optional. It is a critical component of responsible S corporation planning in 2025.

Jessica I. Marschall, CPA, ISA AM

President & CEO

Marschall Accounting Services LLC

The Green Mission Inc.

Probity Appraisal Group

GM-ESG