The $24,000 Salary That Cost a CPA Six Figures

RamthaMedia

A Number Small Enough to Notice

A CPA in California paid himself $24,000 a year. Nothing unusual about that on paper — until you learn his firm brought in six figures in profit on top of it, all of it routed to him as shareholder distributions instead of wages. The IRS noticed the gap before he did.

That case, McAlary v. Commissioner, is one of the reasons S corp tax planning has a reputation for being either the smartest move a small business owner makes or the fastest way to trigger an audit. Both reputations are earned. The line between them is thinner than most owners realize, and it runs straight through a single word: reasonable.

The Split Nobody Explains Clearly

Here is what actually happens inside an S corporation, mechanically. A sole proprietor or a single-member LLC taxed as a disregarded entity pays 15.3% self-employment tax on every dollar of net profit, no exceptions, no workaround. That 15.3% is Social Security and Medicare tax, the same tax an employer and employee split on a paycheck, except the sole proprietor pays both halves alone.

An S corp shareholder who works in the business does not get to skip that tax on all of it — only on part of it, and only if the structure is built correctly. The owner takes a W-2 salary, which is subject to the full 15.3% payroll tax split between the business and the individual. Whatever profit remains after that salary gets paid out as a distribution on Schedule K-1. That distribution is still taxed as ordinary income, but it is not wages, and wages are the only thing FICA taxes. No Social Security tax on it, no Medicare tax on it, and no 0.9% Additional Medicare Tax either.

The legal basis for that gap is not a loophole in the colloquial sense — it is built directly into the tax code. IRC §3121(a) defines FICA tax as applying to wages paid for employment. IRC §1366 defines how S corp profit passes through to shareholders: as a distributive share, not as wages. The IRS itself confirmed this treatment decades ago in Revenue Ruling 59-221, and it has never reversed course. The gap between wages and distributions isn't an oversight. It's the plain text of the statute.

Why Every Dollar Doesn't Split the Same Way

S corp tax savings scale unevenly, and this is where most explanations stop short. The Social Security portion of the 15.3% rate — 12.4 percentage points of it — only applies up to an annual wage base ceiling set by the Social Security Administration. Below that ceiling, every dollar shifted from salary to distribution avoids the full 15.3%. Above it, Social Security tax stops applying to wages entirely, so only the 2.9% Medicare piece remains at stake on additional income.

That means the strategy is most powerful for a business owner whose reasonable salary sits below the wage base, with meaningful profit left over to distribute. It is far less dramatic for someone whose reasonable compensation already exceeds that ceiling, where the savings shrink to the Medicare-only spread. The math rewards mid-size, profitable small businesses more than it rewards either very small operations or high-earning professional practices paying near-market executive salaries.

How the IRS Decides What You Owe Yourself

This is the part of S corp tax planning that generates lawsuits, and it starts with a phrase the tax code takes seriously: reasonable compensation. The requirement traces back to Revenue Ruling 74-44, and the IRS's current operational guidance sits in Fact Sheet FS-2008-25, which states plainly that a shareholder-employee performing services for the company must be paid reasonable wages before any distribution is taken.

The IRS determines reasonableness by asking what an unrelated employer would pay someone with the same role, the same experience and the same hours, doing the same work in the same industry. There is no fixed percentage, no safe-harbor number, no simple formula written into the code. That ambiguity is exactly why it ends up litigated case by case.

Watson v. Commissioner is the case that shows what happens when an owner pushes the salary too low. A CPA structured his compensation with a token salary and took the overwhelming majority of his pay as distributions. The Tax Court didn't just disagree — it reclassified a large share of those distributions as wages after the fact, which meant back FICA tax, penalties and interest, stacked across every year the pattern held. McAlary v. Commissioner reached the same conclusion on similar facts. Both cases involved professionals who understood the tax code well enough to use it, and who lost anyway because they treated 'reasonable' as a suggestion rather than a standard the IRS actively tests.

Who Qualifies for This

Not every business owner has access to this split, and the eligibility rules matter as much as the mechanics. You qualify if your business is taxed as an S corporation — meaning Form 2553 has been filed and accepted — and you are a shareholder who performs services for the company as an employee.

Sole proprietors and single-member LLCs that never made the S election are excluded entirely; they pay self-employment tax on the full amount by default. Partners in a partnership face a different rule altogether — they owe self-employment tax on their entire distributive share, with no salary/distribution split available to them. C-corp owners are dealing with an unrelated problem: double taxation, where corporate profit is taxed once at the entity level and again when distributed as dividends. And a passive S-corp shareholder who does no work for the company doesn't need to take a salary at all — but that also means they were never the intended beneficiary of this particular strategy in the first place.

Building the Structure Correctly

Setting this up starts with the election itself. A business elects S-corp status by filing Form 2553, or, for an LLC, filing Form 8832 followed by Form 2553. The timing matters: the election generally must be filed within two months and 15 days of the start of the tax year the owner wants it to apply to. Miss that window and the earliest possible start date moves out by a full year.

After the election is active, the owner sets a defensible salary — one supported by documentation, not a round number picked because it feels comfortable. A written compensation study, an industry salary survey, or data pulled from sources like RCReports, the Bureau of Labor Statistics, or salary.com gives the number something to stand on if it's ever questioned.

From there, the owner runs that salary through actual payroll: withholding federal income tax, Social Security and Medicare, filing Form 941 quarterly and issuing a W-2 at year-end. Remaining profit gets paid out as periodic shareholder distributions, reported on Schedule K-1, with no FICA withheld against it at all. On the individual's Form 1040, the W-2 salary lands on line 1a, while the K-1 income flows through Schedule E. Both are still taxed at ordinary income rates, which for 2026 run from 10% up to 37% for single filers earning above $640,600 — the FICA savings apply only to the payroll tax layer, not to income tax itself. Many S corp owners are also able to claim the Section 199A qualified business income deduction, which can reduce the taxable pass-through portion by up to 20%, on top of the payroll tax savings already built into the structure.

The $40,000 Line Where Compliance Costs Erase the Savings

S corp tax planning is not free to run. Once the election is active, the business inherits payroll filings, a separate Form 1120-S return, and in some states — California among them — a franchise tax on top of everything else. Those costs are fixed regardless of how much profit the business actually generates.

That fixed cost is why the strategy has a floor. When net profit falls below roughly $40,000, the payroll processing, the separate return, the compliance overhead and the accountant's time typically cost more than the FICA savings the split produces. Above that rough threshold, the math flips decisively: the payroll tax saved on distributions usually outweighs the compliance cost several times over, which is exactly why the strategy remains standard advice for profitable small businesses but a bad fit for a business still finding its footing.

Frequently Asked Questions

What is the S corp tax loophole everyone talks about?

It's not really a loophole — it's a structural feature of IRC §1366. S corp owners split their pay into a W-2 salary, taxed with full 15.3% payroll tax, and a shareholder distribution, which is taxed as ordinary income but skips FICA entirely. Sole proprietors don't get that second bucket.

How much salary do I need to pay myself as an S corp owner?

There's no fixed formula. The IRS looks at what an unrelated employer would pay someone with your role, experience, and hours in your industry. A written comp study or data from sources like the Bureau of Labor Statistics or RCReports helps document that the number is defensible.

📰 Recommended for You

How Canva Turns an Indian Occasion Into a Printed Invitation

Read More →

How Animaker Turns One Prompt Into a Finished Video

Read More →

What happens if the IRS decides my S corp salary is too low?

The IRS can reclassify part of your distributions as wages, which triggers back FICA tax, penalties and interest across every year the pattern existed. Watson v. Commissioner and McAlary v. Commissioner are the two cases most often cited for exactly this outcome.

Is S corp status worth it for a small business with low profit?

Often not. Once you elect S-corp status, you take on payroll filings, a separate 1120-S return, and sometimes state franchise tax. Below roughly $40,000 in net profit, those compliance costs tend to outweigh the FICA savings from the salary/distribution split.

Do S corp distributions avoid all taxes?

No. Distributions still face ordinary income tax at rates from 10% to 37%. What they avoid is the 15.3% self-employment tax, including the 0.9% Additional Medicare Tax — not income tax itself.