Federal Tax Research Memorandum: Reasonable Compensation for S Corporation Shareholder
Memo Overview
This ACCT 553 Federal Taxation research memo evaluates whether an S corporation shareholder’s salary meets the IRS reasonable compensation standard. The memorandum mirrors the structure required in DeVry University’s ACCT 553 course and applies Internal Revenue Code §162, relevant Treasury Regulations, IRS Fact Sheet FS-2008-25, and Tax Court precedents to reach a defensible conclusion.
Course: ACCT 553 Federal Taxes | Client: Thompson Advisory CPAs | Author: Allison Pierce, CPA candidate | Date: January 20, 2025
Key Issues Analyzed
- Facts: Shareholder owns 100% of Lakeview Marketing, takes a $45,000 salary and $180,000 distributions while managing daily operations.
- Issue: Whether the salary constitutes reasonable compensation under IRC §162(a)(1) and associated rulings.
- Authority: IRC §162, Treas. Reg. §1.162-7, IRS Fact Sheet FS-2008-25, Radtke v. United States, David E. Watson, P.C. v. United States.
- Analysis: Compares fair market wages, industry ratios, and shareholder’s services to determine reclassification risk.
- Conclusion: Salary should be increased to $120,000 to align with comparable marketing executives and mitigate payroll tax adjustments.
- Recommendations: Document job duties, adopt payroll benchmarks, and formalize shareholder employment agreements.
Facts
Lakeview Marketing, Inc. is taxed as an S corporation. Its sole shareholder, Emma Lake, manages business development, oversees eight employees, signs all contracts, and controls corporate finances. For 2024 she withdrew $225,000 from the company—$45,000 classified as W-2 wages and the balance labeled as shareholder distributions. Revenue increased 42% year over year, and comparable marketing firms in Chicago pay their CEOs between $115,000 and $155,000 according to Bureau of Labor Statistics (BLS) data and the Robert Half Salary Guide.
Issue
Whether Lakeview Marketing may deduct the entire $225,000 as ordinary and necessary business expenses, or if the IRS will reclassify a portion of the distributions as additional wages because the shareholder’s salary does not reflect reasonable compensation for services rendered.
Authority
- IRC §162(a)(1) – Reasonable allowance for salaries or other compensation for personal services actually rendered.
- Treas. Reg. §1.162-7(a) – Defines reasonable compensation based on services performed.
- IRS Fact Sheet FS-2008-25 – Highlights reasonable compensation expectations for S corporations.
- Radtke v. United States, 895 F.2d 1196 (7th Cir. 1990).
- David E. Watson, P.C. v. United States, 668 F.3d 1008 (8th Cir. 2012).
Analysis
Applying the five-factor test from Watson, courts weigh (1) the employee’s role, (2) external comparisons, (3) character and condition of the company, (4) conflicts of interest, and (5) internal consistency of compensation. Emma Lake functions as CEO, CFO, and lead strategist; her duties mirror executives earning $130,000 in similar firms. The low wage-to-distribution ratio (20%) signals underpayment. IRS FS-2008-25 instructs agents to compare salaries against industry data and reclassify distributions when services are substantial. Given Lakeview’s profitability and Emma’s control, the IRS could recharacterize $75,000 of distributions as wages, triggering payroll taxes plus penalties.
Conclusion
To minimize exposure, Lakeview should increase Emma’s wage to at least $120,000. This aligns with BLS SOC 11-2021 (Marketing Managers) and judicial guidance from Watson. The corporation should contemporaneously document the compensation study, adjust quarterly payroll deposits, and reduce distributions accordingly. Failure to act risks IRS adjustments under IRC §6651 and §6656.
Recommendations
- Prepare annual reasonable compensation benchmarking using BLS, Robert Half, and Risk Management Association data.
- Adopt written employment agreements for shareholder-employees specifying duties and salary bands.
- Segregate time spent on shareholder versus employee tasks to substantiate the wage component.
- Review state unemployment insurance thresholds to ensure compliance after salary adjustments.
Exhibits
- Exhibit A – Comparable salary survey summary.
- Exhibit B – IRS FS-2008-25 excerpt on reasonable compensation.
- Exhibit C – Case law matrix comparing Radtke, Watson, and Sean McAlary Ltd., Inc. vs. Commissioner.
Need Help with Your ACCT 553 Tax Research Memo?
Our graduate tax writers craft custom memoranda that cite current IRS guidance, revenue rulings, and Tax Court decisions. We deliver full fact summaries, issue statements, authoritative analysis, and actionable recommendations tailored to ACCT 553 grading rubrics.
Get Tax Memo Help NowDeliverables Included
- Executive summary formatted to ACCT 553 grading rubric.
- Facts, issues, authorities, analysis, conclusion, and recommendation headings.
- Citator table summarizing IRC, Treasury Regulations, IRS guidance, and Tax Court holdings.
- Client advisory letter translating technical findings into actionable steps.
- Appendix with benchmarking spreadsheets and payroll adjustment schedules.
Instructor Feedback & Grade
Final Grade: A+ (100/100) — Instructor comments highlighted the memo’s concise framing of the reasonable compensation issue, thorough authority discussion, and practical planning recommendations that closely match IRS expectations for shareholder-employees.
Why This Tax Memo Stood Out
- Integrated primary authority citations with pinpoint references to court decisions and IRS publications.
- Used salary benchmarking data to quantify adjustments rather than relying on qualitative statements.
- Presented risks, penalties, and mitigation strategies in a separate advisory section for the client.
- Maintained professional tone and memo formatting consistent with DeVry ACCT 553 requirements.
- Provided a compliance checklist ensuring payroll adjustments are implemented in future quarters.
Primary Authorities Cited
- Internal Revenue Code §162(a)(1)
- Treasury Regulation §1.162-7(a) and (b)
- IRS Fact Sheet FS-2008-25, "Wage Compensation for S Corporation Officers"
- Radtke v. United States, 895 F.2d 1196 (7th Cir. 1990)
- David E. Watson, P.C. v. United States, 668 F.3d 1008 (8th Cir. 2012)
- Sean McAlary Ltd., Inc. v. Commissioner, T.C. Summary Opinion 2013-62
Compliance Tip
Document salary benchmarking annually and retain worksheets in the corporate minute book. The IRS typically requests this evidence during S corporation reasonable compensation audits.