4 Reasonable Comp Mistakes I Saw Most This Tax Season

Tax season is the magnifying glass. The reasonable compensation patterns that look fine in October show up clearly in March when you're reviewing 1120-S returns at volume. After working through this season's S-Corp filings, four mistakes came up often enough across firms and clients that they're worth writing down — not because they're new, but because they're the recurring ones that quietly produce audit exposure.

Each of these is fixable in a single Q2 work session. None require new tools or new systems. They require treating the salary decision as a process with a documented sequence, not a one-line entry on a workpaper.

Mistake 1: Carrying last year's salary forward without rerunning the lookup

The pattern is easy to recognize: the engagement letter promises an annual reasonable compensation review, but the 2026 workpaper is a copy of the 2025 file with the year stamp updated. Salary stays the same. Bonus stays the same. Documentation gets revised by find-and-replace.

This was already a weak posture in stable years. In 2026, it's actively dangerous. The Bureau of Labor Statistics released its May 2024 OEWS dataset in March 2025, and that's the dataset most CPAs cite for this year's analysis. The 2024 data showed wage growth of roughly 4–6% across most occupations S-Corp owners typically map to: healthcare practitioners, financial managers, construction managers, restaurant managers, professional services owners.

The math: if the 2025 reasonable comp report set the salary at $135,000 based on a $148,000 BLS p50 for the occupation, and the 2024 BLS p50 for the same occupation has moved to $156,000, the salary that was previously at the 50th percentile is now sitting closer to the 35th. The W-2 number didn't change. Its position in the band did.

The fix: rerun the BLS lookup every year, even when nothing has changed about the client. Document the fresh percentile in the workpaper. If the salary needs to move up to stay at the same band position, model the FICA cost AND the basis impact — those interact (see mistake #4).

Mistake 2: Documenting reasonable comp after the salary is set

The pattern: the salary was paid through 2025 payroll. In March 2026, the CPA opens a memo, types in the salary that was actually paid, and constructs a justification around it. The workpaper reads as "$X is reasonable because [reasons]" — where the reasons were assembled to defend the number, not derive it.

This is a documentation failure, not a salary failure. The IRS examiner's question is not "is this number reasonable in isolation?" — it's "what process produced this number?" A justification written after the fact reads like one, even when the underlying salary is defensible. Reverse-engineered defenses tend to hit the conclusion (reasonable) without ever admitting that other numbers would also have been reasonable, because the analysis was never run as a true comparison.

Glass Blocks Unlimited v. Commissioner (T.C. Memo. 2013-180) is a useful reference here. The court accepted the salary number after a redetermination, but the case turned in part on the absence of contemporaneous analysis at the time the salary was set. Documentation timing matters separately from documentation content.

The fix: the analysis dates should precede the salary decision. Run the analysis in Q4 of the prior year (or Q1 at latest), set the salary based on the analysis output, and let the workpaper reflect that sequence. Even when the number lands identically to "what was going to be paid anyway," the documentation chronology defends differently in audit.

For a deeper read on what defensible documentation actually contains, see our prior piece on documenting reasonable compensation.

Mistake 3: Treating multi-shareholder pro-rata as a clerical detail

The pattern: a 50/50 S-Corp pays one shareholder $90,000 in W-2 wages and the other $40,000. Both are active in the business. The CPA documents reasonable compensation for each shareholder individually — both numbers fall within their respective bands — and considers it done. Distributions for the year run pro-rata as the single-class-of-stock rule requires.

This construction can look fine on each shareholder's individual basis worksheet, but the IRS has multiple challenge pathways. The lower-paid shareholder is taking the same pro-rata distributions while paying meaningfully less in FICA. Even if both salaries are individually defensible, the disparity itself can be reread as a constructive distribution disguised as wages — particularly when the work each shareholder performs looks similar.

The Watson v. United States line of cases (2010 onward) established that the IRS can reclassify distributions as wages on a per-shareholder basis. What's discussed less frequently: the disparity itself can be evidence the lower W-2 number was set to harvest FICA savings, especially when both shareholders contribute similarly to operations. The audit posture isn't "is each salary reasonable" but "does the disparity reflect actual differences in services rendered."

The fix: when both shareholders perform similar work, the W-2 wages should reflect similar comp. When the work materially differs (one full-time operator, one substantively passive), document that distinction explicitly in the workpaper — with hours, duties, and revenue contribution. The disparity has to be justified by the work, not assumed away.

For more on the multi-shareholder analysis specifically, see our guide on reasonable compensation in multi-shareholder S-Corps.

Mistake 4: Optimizing salary and distributions as independent decisions

This is the one that compounded across the most returns this year. Reasonable comp gets set in one workpaper, focused on BLS data and the IRS reasonableness test. Distribution planning happens in a separate conversation, usually closer to year-end, focused on cash availability and the shareholder's tax bracket. The two analyses never share a worksheet, and the connection between them goes unmodeled.

But the connection is direct. Salary is a corporate expense. Increasing a shareholder-employee's W-2 by $30,000 reduces corporate net income by approximately $32,295 (the salary plus 7.65% employer FICA, capped at the SS wage base where applicable). That reduction flows through K-1 ordinary income to every shareholder pro-rata, which reduces stock basis dollar for dollar.

A worked example

Sole shareholder · 100% ownership · raise of $30,000

+ Employer FICA on raise (7.65%): $2,295

= Corp net income reduction: −$32,295

→ K-1 ordinary income drop: −$32,295

→ Stock basis drop at year end: −$32,295

Tax-free distribution capacity reduced by $32,295.

Decided independently, the two levers can pull against each other. A CPA who raises the salary in Q1 to defend the reasonable comp position can discover in Q4 that the planned year-end distribution now exceeds available basis, triggering capital gain on the excess. The right sequence is to model the salary change AND the basis impact AND the resulting distribution capacity in a single analysis — and to surface the trade-off explicitly to the client: "save $4,590 in FICA on a $30,000 salary cut; lose $16,150 in tax-free distribution capacity for the 50% owner."

The advisor's job is the trade-off conversation, not the spreadsheet. But the spreadsheet has to be honest about what changing one number does to the others. For background on how the basis side of the equation works, our prior piece on S-Corp distribution rules and basis ordering covers the §1367 cascade in detail.

What to do before next tax year

Tax season ended weeks ago. Most CPAs are in the rare window when the client list isn't actively burning, and Q2 is the natural time to install the process changes that prevent next year's version of these mistakes. A short sequence:

Re-run the BLS lookup for every active S-Corp client

Even if you don't change the salary, capture the fresh percentile for the workpaper. This is the single highest-leverage process change because it's the foundation every other decision sits on.

Move salary analysis to Q4 of the prior year

Calendar it. The workpaper date should precede the first payroll run of the new year. This is the documentation timing fix from mistake #2.

Audit your multi-shareholder clients for unjustified disparity

For every S-Corp with more than one active shareholder, confirm the W-2 disparity is documented with hours, duties, and revenue contribution. A short attachment in the workpaper closes this exposure.

Add the basis column to your salary modeling

When you propose a salary change, calculate the corporate net income impact, the K-1 effect, the basis effect, and the resulting distribution capacity. One worksheet, one client conversation.

None of these require new software. They require deciding the salary process is a sequence with a fixed order, run on a calendar, with the basis math attached. The audit posture you carry into next year reflects the process you ran this year.

Frequently Asked Questions

What is the most common reasonable compensation mistake CPAs make?

The most common pattern is carrying last year's salary forward without rerunning the BLS OEWS lookup. Wage data updates annually — a salary that was at the 50th percentile last year can drift below the 25th percentile this year as the underlying wage band moves. The number on the W-2 stays the same; its position in the band does not.

How often should an S-Corp shareholder's reasonable compensation be reviewed?

Annually, and ideally before the tax year begins or in Q1 at the latest. Setting reasonable compensation in advance means the documentation drives the salary decision, not the other way around. CPAs who first prepare the salary analysis in March of the following year are working backward from a number already on the books, which is harder to defend in audit.

Can reasonable compensation be set after the tax year ends?

Reasonable compensation analysis prepared after the year ends is technically valid, but the IRS gives more weight to contemporaneous documentation — analysis that demonstrably preceded the salary decision. Post-year-end memos that justify a number already paid through payroll read as reverse-engineered defenses, even when the underlying salary is reasonable.

Does reasonable compensation need to be the same for each shareholder in a multi-shareholder S-Corp?

Not necessarily, but disparities require explicit justification tied to the actual work each shareholder performs. When two shareholders contribute similarly to operations but receive materially different W-2 wages, the disparity can be challenged as a constructive distribution disguised as wages. The workpaper should document hours, duties, and revenue contribution — not just the final salary number.

How does changing an S-Corp salary affect shareholder basis?

Salary is a corporate expense. Increasing a shareholder-employee's W-2 by $30,000 reduces corporate net income by roughly $32,300 (the salary plus employer FICA), which reduces every shareholder's K-1 ordinary income pro-rata, which reduces stock basis dollar for dollar. For a 50% owner of a sole-shareholder S-Corp, that $30,000 raise shrinks ending stock basis by about $16,150 — directly reducing tax-free distribution capacity.

The 4 Reasonable Comp Mistakes I Saw Most This Tax Season

Mistake 1: Carrying last year's salary forward without rerunning the lookup

Mistake 2: Documenting reasonable comp after the salary is set

Mistake 3: Treating multi-shareholder pro-rata as a clerical detail

Mistake 4: Optimizing salary and distributions as independent decisions

What to do before next tax year

Frequently Asked Questions

Run a fresh analysis before next year

Quick salary risk check

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