Blog · 15 October 2026

S Corporation Reasonable Compensation: Watson, $130,000 in Preparer Penalties and What US CPA Firms Should Document Before Year-End

By Keshav Bansal, CA

S corporation reasonable compensation is usually framed as the owner’s problem: pay yourself a fair salary before taking distributions, or the IRS may recast those distributions as wages. A story reprinted in Bradford Tax Institute’s October 2026 Tax Reduction Letter (flagged on its blog on October 12, 2026) is a reminder that the return preparer can carry part of the risk too. For US CPA firms heading into year-end, the practical answer is the same for both sides: settle the salary and put the reasoning in writing before December 31.

The rule: wages before distributions

The IRS page on S corporation compensation and medical insurance issues (last reviewed March 3, 2026) states that S corporations “must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made.” It quotes the Form 1120-S instructions: distributions and other payments to a corporate officer “must be treated as wages to the extent the amounts are reasonable compensation for services rendered.”

The money at stake is payroll tax. Under the Social Security Administration’s figures, wages paid in 2026 carry 6.2% Social Security tax each for employee and employer up to a $184,500 wage base, plus 1.45% Medicare tax each with no cap. Distributions carry neither. The IRS page says it has authority to reclassify distributions as wages and lists the court support:

• Joly v. Commissioner, T.C. Memo. 1998-361, aff’d (6th Cir. 2000): authority to reclassify.
• Veterinary Surgical Consultants, P.C., 117 T.C. 141 (2001) and Joseph M. Grey Public Accountant, P.C., 119 T.C. 121 (2002): shareholders who work are employees.
• David E. Watson, P.C. v. United States, 668 F.3d 1008 (8th Cir. 2012): what counts as reasonable pay for services.

What Watson shows about “too low”

Watson involved an accountant who held his interest in an accounting firm through his own S corporation. Per the Eighth Circuit’s February 21, 2012 opinion, the S corporation paid him a $24,000 salary in each of 2002 and 2003, while he received $203,651 (2002) and $175,470 (2003) in profit distributions through it. The IRS’s expert relied mainly on the AICPA Management of an Accounting Practice survey and valued his services at $91,044 a year.

The district court adopted that figure and recharacterized $67,044 a year of distributions as wages, and the Eighth Circuit affirmed. The court pointed to his advanced degree and nearly 20 years of experience, his 35 to 45 hours a week as one of the firm’s primary earners, firm gross earnings of over $2 million in 2002 and nearly $3 million in 2003, and how low $24,000 was next to roughly $200,000 of distributions. No documents recorded how the salary had been set.

The preparer side: a $130,000 example

The Bradford issue reprints tax attorney Eric L. Green’s account, first published on RCReports on November 1, 2022, of a CPA client he calls “Bob.” Per Green, the IRS audited several of Bob’s S corporation clients who took little or no salary. Bob only prepared their returns from what they sent him; he did not run their payroll or keep their books, and he said he had urged them for years to take salaries.

Green writes that the IRS assessed $1,000 per client under IRC §6694(a) plus $4,000 per client under §6694(b), for 13 clients in both 2009 and 2010, a total of $130,000. To contest, Bob paid 15% ($9,750 for each year, $19,500 in all) and sued for a refund in district court. The Justice Department agreed to drop its claims if Bob gave up the $19,500; with $15,000 in legal fees, Green puts Bob’s cost at $34,500. Green also warns that a practitioner who does not challenge preparer penalties risks attention from the IRS Office of Professional Responsibility, which Bradford’s summary highlights.

The statute explains the mechanics. Under §6694:

• §6694(a) applies to an understatement due to a position without substantial authority (or without a reasonable basis if disclosed) that the preparer knew or reasonably should have known of. The penalty is the greater of $1,000 or 50% of the income derived from the return, per return, with a reasonable cause and good faith exception.
• §6694(b) applies to willful or reckless conduct, or intentional disregard of rules or regulations: the greater of $5,000 or 75% of the income derived, reduced by any §6694(a) penalty paid.
• §6694(c) lets a preparer pay at least 15% within 30 days of notice and demand, file a refund claim and then sue in district court, which pauses collection of the rest.

Green’s point is not that every low salary means a preparer penalty. It is that an examiner’s first question is where the written support is.

How the IRS frames “reasonable”

The IRS page says the key is the source of the corporation’s gross receipts: the shareholder’s services, non-shareholder employees, or capital and equipment. Receipts from the shareholder’s own work, including management of other income-producing staff, point to wages. Its listed factors are:

• Training and experience; duties and responsibilities; time and effort devoted to the business.
• Dividend history; payments to non-shareholder employees; timing and manner of bonuses to key people.
• What comparable businesses pay for similar services; compensation agreements; use of a formula.

Owner pay also feeds other numbers. S corporation reasonable compensation is excluded from qualified business income (see our QBI deduction §199A 2026 guide), and wage corrections flow into Forms 941-X and W-2c (see the Quick Read on fixing S-corp payroll errors). Unpaid withheld payroll taxes can also become a personal problem for owners, as in our Amodio trust fund recovery penalty post.

A year-end reasonable compensation checklist

1. List every S corporation client where an active owner took no W-2 wages, or wages that look small next to distributions.
2. Ask each owner, in writing, what they did this year: duties, hours, who else generates revenue, and which assets drive receipts.
3. Set a salary using outside compensation data and the IRS factors, and keep a dated memo or third-party report with the corporate records.
4. Run any catch-up wages through payroll before December 31 so withholding and deposits match the 2026 W-2.
5. Keep your engagement letter and file notes showing what you told the client and what they decided, which goes to good faith under §6694(a)(3).
6. For prior years, review the exposure with the client before an examiner does.

Where this fits for Tax Brew readers

This is mostly data gathering: payroll registers, distribution schedules and comparable-pay support. If your team is stretched in Q4, outsourced bookkeeping and tax support for US CPA firms can assemble the file while your professionals make the call. Email info@taxbrewglobal.com.

Sources: Bradford Tax Institute, “Reasonable Compensation Horror Stories: The Tax Man Cometh” (blog October 12, 2026; Tax Reduction Letter, October 2026); Eric L. Green, RCReports (November 1, 2022); IRS, “S corporation compensation and medical insurance issues” (reviewed March 3, 2026); David E. Watson, P.C. v. United States, 668 F.3d 1008 (8th Cir. February 21, 2012); IRC §6694 (Cornell LII); SSA contribution and benefit base for 2026. General information, not tax or legal advice. Sources as of 15 October 2026.