By: John S. Morlu II, CPA
The determination of reasonable compensation is a critical issue for business owners, especially those operating as sole shareholders in S corporations. The IRS often examines whether salary payments to shareholder-employees align with market standards. One notable court case highlighting this issue is the Watson case, which centered on David E. Watson, an accountant and sole shareholder of an S corporation, David E. Watson, PC.
The Case at a Glance
David Watson transferred his partnership interest in a successful accounting firm into his wholly-owned S corporation. From there, he paid himself a salary and also took distributions as the sole shareholder. The IRS challenged these payments, arguing that Watson’s salary was unreasonably low for the work he performed, and sought to reclassify a portion of his distributions as wages subject to payroll taxes.
After hearing the case, the trial court sided with the IRS, a decision later upheld by the appeals court. The appeals case is documented as David E. Watson, PC v. U.S., 668 F.3d 1008 (8th Cir. 2012).
This case serves as a prime example of the importance of setting reasonable compensation for shareholder-employees and outlines the criteria courts may use to determine what is reasonable.
Key Facts and Figures
Watson reported the following payments to himself during 2002 and 2003:
| Year | Salary | S Corporation Distribution | Total Payments |
| 2002 | $24,000 | $203,651 | $227,651 |
| 2003 | $24,000 | $175,470 | $199,470 |
| Total | $48,000 | $379,121 | $427,121 |
Here, salary accounted for only 11% of total payments, while S corporation distributions made up 89%.
The IRS’s Argument: Market Value of Services
The IRS, using an expert witness, calculated the reasonable market value of Watson’s services based on data from the Management of an Accounting Practice survey conducted by the American Institute of Certified Public Accountants (AICPA).
- Baseline Salary: A director-level accountant (non-owner) would earn around $70,000 annually.
- Adjustment for Ownership Role: Owner billing rates are typically 33% higher than those of non-owners, increasing the estimate to approximately $93,000.
- Adjustment for Fringe Benefits: After accounting for non-taxable benefits, the IRS expert determined that Watson’s reasonable annual compensation should be $91,044.
Watson’s Argument: Intent Matters
Watson did not employ an expert witness. Instead, he argued that the court should respect the S corporation’s intent when characterizing payments as salary versus distributions.
The Court’s Decision
The court rejected Watson’s argument, emphasizing the importance of the reasonableness of compensation, not the intent behind the payment characterization. The court referred to regulations that state the designation or medium of payment is immaterial.
The appeals court affirmed the district court’s decision, setting Watson’s reasonable compensation at $91,044. Key factors influencing this decision included:
- Watson’s Experience and Workload: Watson worked 35–45 hours per week, making significant contributions to a highly reputable accounting firm.
- Industry Comparisons: The $24,000 salary was unreasonably low compared to similarly qualified accountants and far below market standards.
- Disparity in Payments: The salary was disproportionately small compared to the large distributions Watson received.
By reallocating Watson’s compensation as follows, the court showed how the payments would appear with a reasonable salary:
| Year | Revised Salary | S Corporation Distribution | Total Payments |
| 2002 | $91,044 | $136,607 | $227,651 |
| 2003 | $91,044 | $108,426 | $199,470 |
| Total | $182,088 | $245,033 | $427,121 |
Under this allocation, salary constituted 43% of total payments, a significant increase from the original 11%.
Takeaways from the Watson Case
The Watson case underscores the importance of setting reasonable compensation for shareholder-employees of S corporations. Courts will prioritize the market value of services over the taxpayer’s intent when characterizing payments.
Key lessons include:
- Market Benchmarks Matter: Use industry surveys or comparable data to establish fair compensation levels.
- Balance Salary and Distributions: While distributions can reflect profit sharing, salaries must align with the value of services provided.
- Avoid Red Flags: Extremely low salaries may attract IRS scrutiny, as they can appear as attempts to minimize payroll taxes.
By adhering to these principles, business owners can ensure compliance with tax laws while avoiding costly disputes with the IRS.
Author: John S. Morlu II, CPA
John Morlu II, CPA, is the CEO and Chief Strategist of JS Morlu, a licensed public accounting and management consulting firm. He has more than 20 years of professional experience in auditing and advisory work, including service as Auditor General of Liberia and FAR and DCAA compliance work at Unisys Federal Systems.
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