If your Maryland LLC or corporation is taxed as an S corporation, one figure on your payroll does more to determine your audit risk than anything else on the return: the salary you pay yourself. Set it well and you capture the core benefit of the S-corp election, which is that only your wages, and not your distributions, carry Social Security and Medicare tax. Set it too low and you hand the IRS its most reliable and most frequently litigated adjustment, because the agency can recharacterize your distributions as wages and bill you for the payroll taxes you skipped, plus penalties and interest.

This is not a fringe enforcement priority. It is one of the most common employment tax issues the IRS pursues against small businesses, and the reason is simple math: an owner who zeroes out salary and takes everything as a distribution avoids a tax that a sole proprietor doing identical work would pay. The permanence of the Section 199A qualified business income deduction starting in 2026 has only sharpened the incentive to keep salaries low, which is exactly why the reasonable compensation question is not going away.

This guide explains, for Maryland business owners, what reasonable compensation means, why the IRS cares, who has to take a salary, how the IRS and the courts decide whether a number is defensible, the red flags that draw an audit, how the salary decision interacts with the QBI deduction, what a reclassification actually costs, and how to set and document a figure that will hold up. If you are still deciding whether the S-corp election makes sense in the first place, start with our guide on the S-corp election for a Maryland LLC and our overview of the tax differences between an LLC and a corporation.

Reasonable compensation is the amount an S corporation must pay a shareholder-employee, as wages, for the services that person actually performs, before the owner takes distributions. The IRS defines it as the amount that would ordinarily be paid for similar services by a like enterprise under like circumstances. The practical test is the one an appraiser would use: what would you have to pay an unrelated person to do your job.

The requirement is not new and it is not obscure. It traces to Revenue Ruling 74-44, in which an S corporation paid its shareholders distributions instead of salaries, and the IRS held that those payments were really wages subject to employment taxes because they were made in lieu of reasonable compensation for services. The IRS carried that position into later guidance and into the instructions to Form 1120S, which state that distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for the services rendered. The substantive rule comes from the federal employment-tax provisions governing corporate officers, including Internal Revenue Code Sections 3121(d), 3306(i), and 3401(c), as applied in Revenue Ruling 74-44 and the related case law. Section 7436 is procedural: in qualifying employment-tax disputes, it gives the Tax Court jurisdiction to review certain IRS determinations concerning worker status and the resulting employment-tax liability.

Two clarifications matter. First, the standard is about the value of services actually performed, not the owner’s theoretical availability, so a passive owner who genuinely performs no services generally has no wage requirement. Second, undistributed S-corp income that a shareholder simply reports on a Schedule K-1 is not, by itself, self-employment income to the shareholder. The reasonable compensation issue arises specifically because the owner is both an employee providing labor and an owner receiving distributions, and the law will not let the labor go unpaid so that the pay can escape employment tax.

To see why this is such a durable audit issue, compare how the two most common pass-through structures are taxed on the owner’s earnings.

A sole proprietor or the owner of a standard single-member LLC generally pays self-employment tax on the business’s net earnings from self-employment. Under Internal Revenue Code Section 1401, the tax generally consists of a 12.4 percent Social Security component, subject to the annual contribution and benefit base, and a 2.9 percent Medicare component without that ceiling. An additional 0.9 percent Medicare tax may apply above the statutory income thresholds. Section 1402 defines net earnings from self-employment and contains important exclusions and limitations.

An S corporation is different. Only the wages the corporation pays are subject to Social Security and Medicare tax. Distributions of the remaining profit to a shareholder are not wages and are not subject to employment tax. That single distinction is the entire tax appeal of the S-corp election for an owner-operator, and it is also the pressure point. If the owner pays a small salary and sweeps the rest out as distributions, the owner shrinks the base on which payroll tax is due. Push that far enough and the salary stops reflecting the value of the owner’s work and starts reflecting a tax objective, which is precisely what the IRS is looking for.

The requirement applies to a shareholder who performs more than minimal services for the S corporation. The Tax Court has made clear that an owner cannot avoid employment tax by characterizing pay for services as a distribution of corporate income, as it held in Veterinary Surgical Consultants, P.C. v. Commissioner, 117 T.C. 141 (2001). A few situations are worth separating out:

• The active owner-operator. This is the core case. If you run the business and generate its revenue, you are a shareholder-employee and your services must be compensated as wages before you take distributions.
• The genuinely passive owner. A shareholder who provides no services and merely holds an investment interest generally has no wage requirement, because there are no services to compensate. The label is not enough, though; the facts have to show a real absence of services.
• The greater-than-2-percent shareholder and health insurance. Health and accident premiums the S corporation pays for a more-than-2-percent shareholder-employee are reported as wages on the owner’s Form W-2 for income tax purposes, although they are not subject to Social Security, Medicare, or federal unemployment tax. This is a common bookkeeping point that owners and even some preparers miss.
• Family members who work in the business. When a shareholder’s family member provides services or capital, the IRS has authority to adjust items to reflect the reasonable value of those services or that capital, which can complicate the analysis in a family-owned company.

If your concern is whether a worker is properly an employee or a contractor rather than how to compensate an owner, that is a different but related characterization question, and our guide on worker misclassification in Maryland addresses it.

There is no formula. Both the IRS and the courts decide reasonable compensation on the facts. In Fact Sheet 2008-25, the IRS listed nine factors that an S corporation should consider when it separates reasonable compensation from distributions:

1. Training and experience
2. Duties and responsibilities
3. Time and effort devoted to the business
4. Dividend history
5. Payments to non-shareholder employees
6. Timing and manner of paying bonuses to key people
7. What comparable businesses pay for similar services
8. Compensation agreements
9. The use of a formula to determine compensation

Courts have organized these into a smaller set of questions: the owner’s role and performance, a comparison to what similar businesses pay for similar services, and the character and financial condition of the company. Some courts have also asked whether a relationship between the company and the owner allowed the parties to disguise distributions as compensation, or the reverse, and whether compensation was paid under a structured, formal, and consistently applied program. Across the case law, the factor that tends to carry the most weight is the comparison to market pay for the services actually performed. That is why credible outside compensation data, rather than a round number, is the heart of a defensible position.

The case law is remarkably one-sided. When an owner performs services and takes distributions without paying reasonable wages, the IRS wins with striking consistency. A few decisions anchor the area.

Watson is the leading case. In David E. Watson, P.C. v. United States, 668 F.3d 1008 (8th Cir. 2012), Watson was an experienced CPA who owned his interest in a thriving accounting firm through his S corporation. The S corporation paid him a salary of $24,000 in each of 2002 and 2003 while distributing roughly $203,000 and $175,000 in those years. The government’s valuation expert, drawing on an accounting-profession compensation survey, concluded that a reasonable salary for Watson’s services was $91,044. The district court adopted that figure and the Eighth Circuit affirmed, so about $67,044 per year was recharacterized as wages subject to employment tax, producing tens of thousands of dollars in additional tax, penalties, and interest. Watson matters because Watson actually paid himself something. The court still found the amount unreasonably low, and it endorsed a valuation-based method for setting the right number.

Zero-salary cases are even clearer. Before Watson, most reasonable compensation cases involved owners who paid themselves no salary at all while taking distributions, which left the courts the straightforward task of reclassifying those distributions as wages. In Joseph M. Grey Public Accountant, P.C. v. Commissioner, 119 T.C. 121 (2002), an accountant who performed substantial services took distributions but no wages, and the Tax Court treated the payments as wages. The Third Circuit reached the same result in Nu-Look Design, Inc. v. Commissioner, T.C. Memo. 2003-52, affirmed at 356 F.3d 290 (3d Cir. 2004). The lesson is blunt: a zero salary combined with distributions is the weakest possible position.

The IRS uses data to select employment tax cases, and reasonable compensation issues tend to surface from a recognizable set of patterns. If several of these describe your return, the salary decision deserves a careful second look. For the broader list of return characteristics that draw scrutiny, see our guide on what triggers an IRS audit.

• Zero or token salary with distributions. No wages, or a nominal wage such as a flat low figure, paired with meaningful distributions, is the clearest trigger.
• Distributions that dwarf salary. A large gap between distributions and wages, particularly a ratio well above the value of the owner’s labor, invites reclassification.
• Salary far below industry norms. Compensation that sits well under what comparable businesses pay for the same role stands out against market data.
• High profit with low officer compensation. A profitable company whose working owner reports little wage income is a mismatch the IRS looks for.
• Round or unexplained numbers. Suspiciously even figures, or a salary that never changes as the business grows, suggests a target rather than a market rate.
• Sudden drops without a reason. A salary that falls sharply without a documented change in duties or company finances reads as tax-driven.

None of these is automatically fatal, and a business can have a legitimate explanation for any of them. The point is that the explanation and the supporting data should exist in your file before an examiner ever asks.

The reasonable compensation decision does not happen in isolation. It interacts with the Section 199A qualified business income deduction, and the One Big Beautiful Bill Act made that interaction a permanent feature of planning by eliminating the deduction’s scheduled expiration beginning in 2026. Two effects pull in opposite directions.

• Salary lowers your QBI. Reasonable wages paid to an S-corp owner are not qualified business income. Every dollar of salary is a dollar that does not qualify for the up-to-20-percent deduction, so raising salary shrinks the deduction base. Standing alone, that argues for a lower salary.
• For higher earners, too little salary caps the deduction. Above the taxable income thresholds, the deduction for a business is limited by reference to the W-2 wages the business pays (broadly, a percentage of those wages, with an alternative that also counts a percentage of qualified property). If the business pays very little in wages, that limitation can throttle the deduction below the full amount. For those owners, paying more wages can actually preserve more of the deduction.

The result is a genuine optimization problem for higher-income owners of non-service businesses, where there is a salary level that balances payroll tax against the wage-limited deduction. For owners of a specified service business, which includes fields such as law, health, accounting, consulting, and financial services, the deduction fully phases out once taxable income climbs above the upper threshold. Above that point there is no deduction left to protect, so the wage-limitation planning disappears and only the payroll-tax analysis remains.

When the IRS concludes that a salary was unreasonably low, it does not simply disagree on paper. It can treat a portion of the payments or distributions to a working shareholder as wages under the federal employment-tax rules and Revenue Ruling 74-44, and the consequences compound:

• Back employment taxes. The reclassified wages become subject to Social Security and Medicare tax, both the employer and employee shares, up to the applicable wage base for the Social Security portion.
• Penalties. Exposure can include failure-to-deposit, failure-to-pay, failure-to-file, and information-return penalties, depending on the particular failures involved. Related income-tax adjustments may create additional penalty exposure in appropriate cases.
• Interest. Interest accrues on unpaid tax and penalties from the original due dates, which can be years earlier by the time an audit concludes.
• Trust Fund Recovery Penalty risk. Unpaid employment taxes can expose responsible persons to a personal penalty equal to the trust fund portion of those taxes. Our guide on the Trust Fund Recovery Penalty explains how that liability reaches individuals.
• Collateral effects. An adjustment in one year invites examination of others, and the recharacterization can ripple through the QBI deduction, retirement plan contributions tied to W-2 wages, and state filings.

There are defenses and procedural rights at every stage. Penalties often turn on whether the IRS followed its own requirements, including the supervisory approval rule, a subject we cover in our post on Section 6751(b) penalty defense. A proposed adjustment can be contested through the examination and appeals process, as outlined in our ten steps to navigate a civil tax controversy and our overview of IRS and state tax appeals. And if tax is ultimately owed, there are structured ways to resolve it, which we address in our guide on tax debt and collections defense.

Because these cases are decided on facts and documentation, the winning move is to create the record contemporaneously, not to assemble it after an examiner sends a letter. A defensible reasonable compensation file generally includes the following.

• A written job description. Spell out what the owner actually does, the functions performed, the skill involved, and the hours worked. If the owner wears several hats, describe each and the share of time it takes.
• Market compensation data. Gather figures for those duties from credible sources such as Bureau of Labor Statistics occupational data, reputable salary surveys, or a formal compensation study. Use more than one source to build a defensible range rather than a single point.
• A written analysis applying the IRS factors. Walk through the Fact Sheet 2008-25 factors against your facts and explain how you arrived at the number. This is the document that answers an examiner’s first question.
• Corporate approval. Approve the salary in corporate minutes or a written consent, ideally at the start of the year, so the compensation reflects a deliberate decision rather than a year-end plug.
• A review cadence. Commit to revisiting the salary when the owner’s role changes, when the company’s finances change materially, or when new comparable data becomes available, and document each review.
• Clean payroll mechanics. Run the salary through actual payroll with timely deposits and a Form W-2, and keep distributions clearly separate in the books. Sloppy bookkeeping undercuts an otherwise reasonable number.

Reasonable compensation is primarily a federal employment-tax issue. Maryland generally taxes the shareholder’s wages and the shareholder’s pro rata share of S-corporation income, subject to Maryland additions, subtractions, credits, and other applicable rules. The shareholder generally reports the pass-through income whether or not the corporation distributes the corresponding cash, and a distribution is generally not separately taxable to the extent it does not exceed the shareholder’s stock basis. Accordingly, changing the division between wages and pass-through business income ordinarily does not eliminate Maryland income tax, although it can affect payroll withholding, deductible business expenses, federal adjusted gross income, the Maryland pass-through entity tax election, and other components of the overall calculation. That said, Maryland matters in several concrete ways for owners here, including in Rockville and the surrounding Montgomery County market.

• Withholding on wages. The salary the S corporation pays the owner is subject to Maryland income tax withholding, handled through the same payroll process as the federal withholding.
• Form 510 and the entity-level election. Maryland S corporations file Form 510, the Pass-Through Entity Income Tax Return, which reports the shareholder’s distributive or pro rata share of income. They may also elect to pay Maryland tax at the entity level on Form 511 under the pass-through entity tax, which is designed to preserve a federal deduction at the entity level and generates a credit for the owners on their Maryland returns. The election has technical consequences, especially for S corporations with both resident and nonresident owners, so it should be evaluated with a professional. The Comptroller of Maryland publishes the forms and guidance, including its technical bulletin on the taxation of pass-through entities.
• The county income tax. Maryland imposes a local income tax in addition to the state income tax. For 2026, Montgomery County, where Rockville is located, has a local income-tax rate of 3.20 percent. That is among Maryland’s higher local rates, though it is not the highest statewide; Dorchester and Kent Counties impose 3.30 percent for 2026. Maryland local income tax generally applies through the shareholder’s Maryland taxable income, which may include wages and pass-through business income. It does not apply merely because the corporation makes a cash distribution; the underlying pass-through income and the shareholder’s basis determine the income-tax treatment.

None of these Maryland features changes the core federal analysis, but they affect the total tax picture and the mechanics of paying yourself, and they are part of what we coordinate for owners as part of general counsel and tax work.

• Paying zero salary while taking distributions. This is the weakest position in the entire area and the easiest for the IRS to adjust.
• Trusting a percentage or a calculator. The 60/40 rule and similar shortcuts are not the law. Reasonable compensation depends on the services performed, not a fraction of profit.
• Setting the number once and never revisiting it. A salary that stays flat while the business grows drifts away from a market rate and looks tax-driven.
• Skipping the documentation. A defensible number with no contemporaneous file is far weaker than the same number backed by data and minutes.
• Optimizing the QBI deduction below a defensible salary. The deduction math never overrides the reasonable compensation floor.
• Mishandling owner health insurance. Premiums for a greater-than-2-percent shareholder belong on the Form W-2 for income tax purposes, and getting this wrong is a common and avoidable error.
• Confusing this with the LLC rules. The salary-versus-distribution planning is specific to the S-corp election. A standard LLC taxed as a sole proprietorship or partnership does not get the same treatment, because self-employment tax generally reaches the owner’s full share.
• Waiting until the audit to get help. The strongest time to build the record is before you file. The second-strongest time is the moment the IRS makes contact, not after positions have hardened.

Reasonable compensation is the amount an S corporation must pay a shareholder-employee as wages for the services that person actually performs before the owner takes tax-favored distributions. The IRS defines it as the value that would ordinarily be paid for similar services by similar businesses under similar circumstances. The requirement traces to Revenue Ruling 74-44, where the IRS held that distributions paid to shareholder-employees in lieu of reasonable compensation for services are really wages subject to employment taxes. The instructions to Form 1120S say the same thing: distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered. In plain terms, you cannot convert pay for your labor into a distribution simply by calling it one.

No. There is no IRS-approved percentage, ratio, or safe harbor, and the widely repeated 60/40 rule has no basis in the tax law. Reasonable compensation is a facts-and-circumstances determination based on the services the owner performs, not a fraction of profit or revenue. Any tool or preparer that promises a magic percentage is offering a rule of thumb, not the legal standard. The correct question is what an unrelated employer would have to pay someone to do the specific work the owner does, for the hours the owner works, in that industry and market.

The IRS and the courts weigh facts and circumstances. IRS Fact Sheet 2008-25 lists nine factors: training and experience; duties and responsibilities; time and effort devoted to the business; dividend history; payments to non-shareholder employees; timing and manner of paying bonuses to key people; what comparable businesses pay for similar services; compensation agreements; and the use of a formula to determine compensation. Courts have grouped these into three broad categories: the employee’s role and performance, comparison to what similar businesses pay for similar services, and the character and condition of the company. Comparable market pay for the services actually performed tends to carry the most weight.

If salary is unreasonably low, the IRS can treat some payments or distributions to a working shareholder as wages under the federal employment-tax rules and Revenue Ruling 74-44. Section 7436 may provide Tax Court review in qualifying employment-status proceedings, but it is not the substantive source of the rule. The reclassified amount becomes subject to Social Security and Medicare taxes, and the corporation and the owner can owe back employment taxes plus penalties and interest. In David E. Watson, P.C. v. United States, 668 F.3d 1008 (8th Cir. 2012), a CPA who paid himself a $24,000 salary while taking distributions of roughly $200,000 a year had his reasonable salary set at $91,044, with about $67,044 per year recharacterized as wages, generating tens of thousands of dollars in additional payroll taxes, penalties, and interest. Penalties may include failure-to-deposit, failure-to-pay, failure-to-file, and information-return penalties depending on the failures involved, related income-tax adjustments can create additional penalty exposure, and an unpaid employment tax balance can expose responsible persons to the Trust Fund Recovery Penalty.

It can, and the One Big Beautiful Bill Act made this a permanent planning question by eliminating the sunset of the Section 199A qualified business income deduction beginning in 2026. Reasonable W-2 wages paid to an S-corp owner are not qualified business income, so a higher salary reduces the income eligible for the 20 percent deduction. At the same time, for owners above the taxable income thresholds, the deduction is limited by reference to the W-2 wages the business pays, so too little salary can cap the deduction. For owners of specified service businesses, such as law, accounting, health, and consulting, the deduction fully phases out above the upper income threshold, which removes the wage-limitation planning entirely and leaves only the payroll-tax analysis. The interaction is fact-specific, and the reasonable compensation floor still controls: you cannot set salary below a defensible level just to optimize the deduction.

The analysis depends on the services performed and on whether the shareholder received, or was entitled to receive, cash, property, or other economic benefits from the corporation, not solely on whether the corporation formally labeled a payment as a profit distribution. If the corporation made no payments or transfers to the shareholder, directly or indirectly, there may be no amount available to recharacterize as wages for that year, and the IRS states that reasonable compensation will not exceed the amount the shareholder received directly or indirectly. But personal expenses paid by the corporation, purported loans, management fees, property transfers, and other economic benefits may still be treated as compensation. Courts have required a salary even for owners of modestly profitable or struggling businesses when the owner received distributions or other benefits, as in Joseph M. Grey Public Accountant, P.C. v. Commissioner, 119 T.C. 121 (2002). Paying zero salary while taking meaningful distributions is the single clearest reasonable-compensation red flag.

Build the file before you file, not after an auditor asks. A defensible record usually includes a written description of the owner’s duties and the hours worked, market compensation data for those duties (for example Bureau of Labor Statistics figures and reputable salary surveys or a compensation study), a written analysis applying the IRS factors to your facts, corporate minutes or a written consent approving the salary, and a note to revisit the number when the owner’s role or the company’s finances change. Contemporaneous documentation matters far more than a number picked at year end, because the courts evaluate the economic substance of what happened, not the label the taxpayer chose.

It is primarily a federal issue, because the tax at stake is the federal payroll tax on wages, and Maryland generally taxes an owner’s wages and pro rata share of pass-through income whether or not the corporation distributes the cash. Maryland still matters in three ways. First, wages paid to the owner are subject to Maryland income tax withholding. Second, Maryland S corporations file Form 510, which reports the shareholder’s distributive or pro rata share of income, and they may elect to pay tax at the entity level on Form 511 under the pass-through entity tax, which preserves a federal deduction and produces a credit for the owners. Third, Maryland imposes a local income tax in addition to the state tax, and Montgomery County, where Rockville is located, has a 3.20 percent local income-tax rate for 2026; that rate applies through the owner’s Maryland taxable income, including applicable wage and pass-through income, rather than merely because the corporation makes a distribution.

Yes, in a different way. There is no employment-tax benefit to overpaying, because every dollar of salary above a reasonable level carries payroll tax that a distribution would not, and a higher salary also reduces the income eligible for the Section 199A deduction. Excess salary also creates rigid payroll obligations and can strain cash flow. The goal is not the lowest number you can justify or the highest number you can pay, but a defensible market rate for the services performed. For most owners the risk is underpayment, but overpayment wastes money and, in the C corporation context, can raise the opposite reasonableness question.

Setting the number each year is often handled with your accountant, and good bookkeeping and payroll are essential. A tax attorney becomes valuable when the stakes or the exposure rise: when the IRS opens an employment tax examination, when distributions have dwarfed salary for several years, when the reasonable compensation question overlaps with entity structure or an ownership change, or when penalties and a possible Trust Fund Recovery Penalty are on the table. Attorney involvement also carries confidentiality protections that differ from those available to a return preparer. The most durable approach pairs sound accounting for the annual number with legal analysis of the documentation and the audit risk.