Reasonable Compensation and the S Corp Owner
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Reasonable Compensation and the S Corp Owner

Reasonable Compensation and the S Corp Owner

Reasonable Compensation and the S Corp Owner

Reasonable compensation and the S Corp owner is a case study of a multiyear dispute with the IRS over an owner’s fair employee compensation. The file in question was shepherded through the IRS Appeals function, reconciling a statutory notice of deficiency.

This CASE STUDY is shared for owners of S-corporations who are challenged by or concerned about their annual wages.

The file that captured my attention and is reviewed here was that of a ‘professional gambler’ in Colorado who structured his highly successful gambling operation as an S-corporation and whether that S-Corp paid the Owner reasonable compensation in tax years 2019 and 2020 for services rendered that are reasonably commensurate with industry norms. Prepare to get into the weeds.

The bottom line is don’t do dumb stuff (DDDS)

Suppose you are pulling in mid-7 digits gambling regularly and consistently. In that case, you better have more than a set of ‘sophisticated spreadsheets’ to assert that you are more than a “deemed” personal service corporation.
When actively or materially participating in the operations of a profitable S-Corp that you own, pay yourself a reasonable salary that indicates where the corporation is at its business development life cycle and commensurate with industry norms in your market.
Subject your wages to Social Security,  Medicare, and federal and state income tax withholding.
For example, IRS Form 1120-S that reports ordinary business income on line 21 will be systematically routed to the IRS Employment Tax operating unit for audit consideration if line 7 Officer Compensation or line 8 Salaries/wages is silent (blank). 

If you have made it this far, you know that S corporations are business entities taxed differently than others. One key difference is that S corporation profits and losses directly pass through to the shareholders, who report them on their tax returns. This means the S corporation does not pay income tax on its profits.

To qualify for this pass-through taxation, an S corporation must meet specific requirements, one of which is an ‘expectation’ that it provides ‘reasonable compensation’ for its shareholders, who are also employees. Reasonable compensation is the salary commensurate with industry standards for the services an employee provides to the company.

What the IRS does

The IRS may challenge the reasonableness of an S corporation shareholder’s salary if it is too low relative to the company’s profits. If this happens, the IRS may reclassify part of the shareholder’s salary as a distribution, which is not subject to employment taxes. This can result in additional taxes and penalties for the shareholder and the company.

To determine reasonable compensation, the IRS looks at various factors, including the nature of the work performed, the employee’s qualifications, the company’s size and financial condition, and other industry standards addressed below. It is essential for S corporation shareholders to carefully consider these factors when setting their salaries to avoid potential challenges from the IRS.



Taxpayer’s business overview

Even though the company is structured as an S-Corp and, as such,  deemed a disregarded entity for income tax payment purposes. In this post, the Company, and the Taxpayer are synonymous. Of course, the company’s Owner ultimately incurs the income tax burden and is referred to separately and distinctly from the company (or Taxpayer) for this analysis as it is the company being examined for failing to render adequate compensation to the employee/owner.

The Company or the Taxpayer is a domestic corporation registered and domiciled in Colorado. The company received IRS Commissioner approval to comport itself as an S-corporation for federal income tax purposes and reports income on IRS Form 1120-S.

The company is owned entirely by a fantasy sports professional player, the sole full-time employee of the company that engages in high-profile sports betting known as daily fantasy sports (DFS) and formerly in card betting in poker. The Owner serves as the company’s President, Officer, Director, and Software Maintainer.

What the Company Does

The company places wagers on a wide variety of sports. The stakes are placed online from the company owner’s home in Colorado and on the Taxpayer’s behalf. On occasion, the owner/taxpayer travels to Las Vegas, Nevada, for in-person participation in tournaments or other local events for sponsored conferences, both on the Taxpayer’s behalf. 1

Think of the movie Money Ball, with exponentially bizarre stats accumulated, tracked, analyzed, and applied to a gambling operation and placing wagers. The Owner works for the Taxpayer daily, from 2 hours to 12 hours, depending on betting schedules making extensive use of developed software to assist in placing bets.

When not gambling, the Owner conducts gambling-related research, budgeting, forecasting, and modeling for the Taxpayer.2 Besides betting and related activities, the Owner spends 500 to 600 hours annually maintaining and improving the Taxpayer’s software. 3

Business classification

The first lesson is to get that business activity code on the tax forms to a standard.

The North American Industry Classification System or NAICS is the standard used by Federal statistical agencies in classifying business establishments to collect, analyze, and publish statistical data related to the US business economy.

NAICS uses a six-digit coding system to identify particular industries and their placement in this hierarchical structure of the classification system. The first two digits of the code designate the sector, the third digit represents the subsector, the fourth digit represents the industry group, the fifth digit represents the industry, and the sixth digit represents the national industry. A zero as the sixth digit generally indicates that the NAICS and US industries are identical. 4

For FYE 2019 and 2020, the Taxpayer reported that it is engaged in the Business Activity of Online Contests and provides the Product or Service of DFS Contests.5 According to the Taxpayer, these activities and services fall under NAICS 713200.

While the 6-digit NAICS 713200 does not exist per se, the 4-digit NAICS 7132 corresponds to the Gambling Industries Group and carries the following description:

“This industry group comprises establishments (except casino hotels) primarily engaged in operating gambling facilities, such as casinos, bingo halls, and video gaming terminals, or the provision of gambling services, such as lotteries and off-track betting. Casino hotels are classified in Industry 72112, Casino Hotels. “6

Taxpayer’s actual classification

 The NAICS code that reflects the business activities of the Taxpayer is 713290. NAICS 713290 corresponds to Other Gambling Industries. Specifically,

“This industry comprises establishments operating gambling facilities (except casinos or casino hotels) or providing gambling services.” 7

The Taxpayer agreed that NAICS 713290 is the correct code for the business activities and services of the Taxpayer. 8


Select financial metrics and officers’ compensation.

In 2019, the Owner received $127,200 as compensation for services and $2,234,665 in ordinary business income. In 2019, the Owner received $116,192 as compensation for services and $2,624,758 in regular business income.

Exhibit A below presents the reported compensation for the Owner, along with the Taxpayer’s revenues, total assets, and said ordinary income.

2019 2019 2020
Form 1120-S 1120-S 1120-S
Tax return data as As revised in the audit
Total assets 3,201,256 656,612
Gross Receipts 2,397,645 3,389,291 * 2,828,727
Cost of Goods Sold
Other Income
Ordinary Business Income 2,234,665 3,113,952 * 2,624,758
Compensation of Officers 127,200 127,200 116,192
Taxes and Licenses 10,041 9,193
Salaries and Wages
Employee benefits 3,170
Other deductions 25,739 75,414
Total deductions 162,980 200,799

Ordinary Business Income/Gross Receipts(%)







Compensation of Officers/Gross Receipts (%) 5.31% 3.75% 4.11%

Ordinary Business Income/Total Income (%)







Compensation of Officers/Total Income(%) 5.3% 3.8% 4.1%
Compensation of Officers and Ordinary Business Income 2,361,865 3,241,152 2,740,950

* During the audit, the Taxpayer revised its 2019 Gross Receipts and Ordinary Business Income.

Taxpayer’s compensation analysis

The Taxpayer does not have a formal policy concerning the officer’s compensation. According to the Taxpayer, the Owner’s 2019 compensation was set to coincide with the maximum amount taxable for Social Security purposes.


Whether the reported compensation deductions for the Owner’s services in 2019 and 2020 were reasonable.

Taxpayer’s Position

The reported compensation deductions for the Owner’s services were reasonable.

Engineer’s Position

Reported compensation deductions of the Owner’s services were understated in both years. Support for the Engineer’s position is presented in the Analysis section of this report.

Applicable Law

Reasonable Compensation under IRC §162

Internal Revenue Code (IRC) §162 includes, among the “ordinary and necessary” expenses deductible by a business, a “reasonable allowance for salaries or other compensation for personal services rendered.” 9

This clause forms the basis for the law of reasonable compensation and empowers the Service to review compensation arrangements between an employer and an employee.

Treasury Regulations §1.162-7 Compensation for Personal Services – says that “the test of deductibility in the case of compensation payments 1s whether they are reasonable and are n, fact, payments purely for services”. 10

“In any event, the allowance for the compensation paid may not exceed what is reasonable under all the circumstances. It is, in general, to assume that reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances. The circumstances to be taken into consideration are those existing at the date when the contract for services was made, not those existing at the date when the contract 1s questioned.” 11



IRC §162 establishes a two-prong test that determines whether an allowance for compensation is deductible:

  1. Whether the payment was purely for services that were rendered, and
  2. If the amount of compensation deduction is reasonable.
Provision of services

The Owner provided the Taxpayer with the services of a professional gambler full-time in 2019 and 2020. In addition, the Owner offered significant and specialized software support to the Taxpayer.

Reasonableness of the reported compensation

Tres. Regs. §1.162-7 requires that the amount of compensation be reasonable. Whether an amount is good is based on the facts and circumstances of an individual case.

A complete analysis of reasonable compensation includes an evaluation of the internal and external factors that influence the level of payment, as well as those factors that may serve as indicators that settlement was for services rendered or that it was actually for bearing the risk of investment.

Generally, courts approach the issue of reasonable compensation by analyzing multiple factors affecting the payment setting. The courts also employ the so-called ‘independent investor’ test. This section focuses on the analysis of various factors affecting compensation.

In the case of Elliotts’ Inc. v. Commissioner12, the court established five factors considered when selecting the reasonableness of officer owners’ compensation deduction. Other court cases suggest additional and overlapping factors. However, Elliotts appear to combine such other element in a concise 5-factor model.

Although each of Elliotts’ factors is broad, they aid in assessing the reasonableness of the reported compensation.

The five factors are:

  1. Role of the employee
  2. The character and condition of the company
  3. An existence of conflicts of interest
  4. Internal Consistency with the treatment of payments to other employees; and
  5. The comparison of compensation with similar officers at similar companies.

Consideration is given to all factors since the factors interrelate with one another. Below is the application of the Elliotts factors to the Owner’s circumstances.

  1. Role of an Employee

Relevant considerations concerning an employee’s role in the company include the position held by the employee, hours worked, duties performed, and the employee’s general importance to the company’s success. The IRS interpretation of the fact pattern in this case file was as follows:

  • While the Owner received occasional secretarial assistance from a part-time employee, the Owner ran all aspects of the Taxpayer’s business.
  • The Owner was primarily or solely responsible for conducting research, programming, budgeting, forecasting, and modeling.
  • The Owner solely and single-handedly generated the Taxpayer’s total annual revenues.
  • It is the Owner’s expertise to create and maintain proprietary software and is responsible for the Taxpayer’s winnings in selecting favorable combinations of bets.
Occupational Outlook Handbook

According to the Occupational Outlook Handbook 13, published by the US Bureau of Labor Statistics, Top Executives devise strategies and formulate policies to ensure these goals and objectives are met. They plan, direct, and coordinate the operational activities of companies and public or private-sector organizations.

“In small organizations, such as independent retail stores or manufacturers, a partner, an owner, or a general manager often is responsible for purchasing, hiring, training, quality control, and day-to-day supervisory duties. In large organizations, top executives not only direct the overall organization but also may be responsible for implementing strategies and setting the overall direction of a certain area of the company or organization.”

“Top executives are among the highest paid workers; however, long hours, considerable travel, and intense pressure to succeed are common.” Specifically, “Long hours, including evenings and weekends, are standard for most top executives and general managers, although their schedules may be flexible.” 14

IRS position

While the Occupational Outlook Handbook does not explicitly address professional bettors, gamers, or gamblers, it has various position descriptions for gaming operators and support staff. Such staff primarily discharges their duties at casinos, racetracks, gaming areas, and table gaming operations. Such a team does not bet or gamble on someone’s behalf. Instead, the staff support organized gambling operations. Gaming professions that are not explicitly listed are classified as “Gaming Service Workers, All Other” and are described as:

“All gaming service workers not listed separately.” 15

The Owner’s duties could be reasonably classified as those of a Top Executive and a professional gambler (Gaming Service Worker).

  1. Character and Condition of the Company

The character (sector and industry in which the company operates) and condition of the company (performance relative to firms in its peer group) impact the determination of a reasonable compensation deduction.

For service businesses that do not depend on heavy capital investment, the size, and complexity are best assessed by comparing the Taxpayer to firms with a similar level of revenue. A compensation comparison is typically made based on company income on the theory that higher income may be due to the efforts of the company management.

The Service consulted Risk Management Association’s (RMA) Annual Statement Studies to gauge the Taxpayer’s performance relative to its peer group. 16

RMA’s Annual Statement Studies

RMA is a trade association of lending institutions and credit risk professionals that compiles composite financial data on manufacturing, wholesaling, retailing, Service, and contracting lines of business.

The association members collect financial statements during the process of loan underwriting. RMA then presents widely used accounting and financial ratios in a standard size form and organized by NAICS codes.

As previously discussed, NAICS 713290, Other Gambling Industries best characterizes the Taxpayer’s activities during the years under audit.

Companies classified under the same NAICS code and similarly sized by annual revenue are considered the Taxpayer’s peers.

Data in the electronic vision of the Annual Statement Studies is supplied on both national and regional bases. 17

RMA divides the country into six regions, with the West region encompassing the states of Alaska, Arizona, California, Colorado, Guam, Hawaii, Idaho, Kansas, Montana, Nebraska, Nevada, New Mexico, Oregon, Utah, Washington, and Wyoming.

RMA’s Annual Statement Studies – woefully inadequate and laughable at best for the following reasons

A review of the RMA’s regional statistics for companies whose total annual revenues are under $3 million indicated that no data was published each year due to a small size.

The sample size was too small and thus was not published. RMA does not publish industry statistics for revenues categories that have too few data points to preclude:

  • Skewing of statistics by outliers
  • Unmasking of individual companies.
Here is where the film gets interesting
  • The RMA national statistics for companies with total annual revenues under $3 million are unavailable.
  • Apparently, establishments providing gambling services may generally need a larger scale to operate successfully and may employ more than a single full-time person.
  • While an ideal set of comparable firm statistics is unavailable, RMA does provide profitability data on more prominent companies in the same industry as the Taxpayers.
  • This analysis relies on the financial data from larger companies classified under the same NAICS code as the Taxpayer to make inferences about the Taxpayer’s performance.
  • Specifically, the RMA data extract presented 1n Attachments A and Bare used in the Service’s analysis.
OF COURSE – The Taxpayer disagreed – and won concessions!
IRS Engineer Position

In 2019, the Taxpayer realized an ordinary business income of 93.2% (on the filed return) and 91.88% (from revised figures provided during the audit) compared with the median profit of 23.3% at companies in the same industry as the Taxpayer. That is, the ordinary business income was about 300% higher than the observed median profit in the industry.

In 2020, the Taxpayer realized an ordinary business income of 92.8% compared with the median profit of 15.6% at companies in the same industry as the Taxpayer. That is, the regular business income was nearly 500% higher than the observed median profit in the industry.

The Taxpayer’s ordinary business income for both years is significantly higher than the median industry profit. In 2019, the Taxpayer’s regular business income exceeded the industry’s profit by about 300%; in 2020, the revenue exceeded the industry’s profit by nearly 500%.

My position

Regrettably, no officers’ compensation statistics were reported by the RMA for this industry in either 2019 or 2020, rendering the IRS Engineer position unreliable. This factor cannot be applied to our analysis. 

3. Conflict of Interest
IRS Engineer Position

A potential conflict of interest may exist in a controlling shareholder’s case because the officer-owner has an incentive and an unabated authority to characterize compensation as distributions, thus lowering his FICA and Medicare tax obligations.

The existence of independent minority investors may mitigate the appearance of a conflict of interest, and an independent Board of Directors puts in place a substantiated and well-reasoned compensation structure.

There is no formal compensation policy for the Taxpayer relative to the Owner.

The Taxpayer does not have a Board of Directors. The Taxpayer did not use comparative analysis, formulas, or guidelines to determine the reasonableness of the compensation reported by the Owner. The payment was set at the upper limit of Social Security taxation, but the Taxpayer did not justify the reasonableness of such a level of the Owner’s remuneration.

My Position

The Taxpayer and the Owner of the Taxpayer are not conflicted. The Owner’s formal compensation policy required total funding of Social Security contributions in both tax years.

4. Internal Consistency

This factor compares the compensation deduction of officer-owner to the compensation levels of non-owner employees. Since the Owner is the sole full-time employee of the Taxpayer, this factor cannot be applied.

Market Compensation

One of the most critical elements in determining reasonableness is the comparison of the compensation in question with compensation paid for similar services by similar enterprises.

In determining whether the compensation deduction of the Owner is comparable to compensation paid by similar enterprises, the market approach is the most appropriate valuation methodology. Applying the market approach examines what similar enterprises pay for similar services under similar circumstances.

RMA’s Annual Statement Studies

The previously discussed RMA Annual Statement Studies provide a ratio of “Officers’, Directors, and Owners’ compensation to sales.” Knowing a company’s annual sales, the balance may be used to estimate the prevailing officers’ remuneration. However, this ratio was not published for NAICS 713290 in 2019 and 2020, presenting a difficulty for analysis.

With a direct method of assessing compensation unavailable, an indirect way of estimating payment for services of the Owner may be employed.

After accounting for all expenses, the median profit before tax in the industry was 23.3% in 2019 and 15.6% in 2020. On the other hand, the Taxpayer reported ordinary business income of 93.2% (91.88% as revised during an audit) and 92.8% in the same respective years. This excess return is primarily or exclusively due to the Owner’s extraordinary talents and efforts.

IRS unreasonably reliance observations

To address the reasonableness of the Owner’s reported compensation, one must ask whether the Taxpayer could replace the Owner and generate returns far over the industry.

The Taxpayer may be able to replace the Owner. Still, it is unlikely, and it may be impossible to pay his replacement the current compensation level while expecting exceptional returns.

Someone of the Owner’s abilities would demand far higher compensation than has been reported for the Owner’s services. A likely outcome for the Taxpayer is to engage someone who may deliver returns commensurate with the industry but not provide excessive returns. This means the unreasonable returns would be paid to the Owner’s hypothetical replacement as compensation for services.

My observations

Analysis of the factors as applied to the Owner leads to the following observations:

  1. Notwithstanding the titles of the Taxpayer’s President, Officer, and Director, the Owner’s most important role was that of a professional bettor and gambler acting on behalf of the Taxpayer.
  2. In 2019 and 2020, the Taxpayer had significantly higher profitability (ordinary business income) relative to the In fact, the Taxpayer’s performance was several hundred percent higher than that of the industry.
  3. There are no formal policies on compensation, and the sole Owner has the latitude to characterize ordinary business income; however, he sees this as a potential conflict of interest.
  4. Compensation deduction for the Owner is set about the maximum amount of pay subject to the Social Security taxes. When the Owner’s compensation is viewed through the lens of the Taxpayer’s financial performance, it appears unlikely that the Taxpayer would find or retain a hypothetical replacement for the Owner while paying the same level of compensation.
5. Normalization of the reported compensation for the Owner

A reasonable level of compensation is generally considered to be the cost of employing someone else to perform services at like enterprises.

The Taxpayer’s financial performance exceeds that of its industry by 4- to 5-fold – a remarkable achievement. The Service contends that it is unlikely that the Taxpayer could replace the Owner with an employee delivering the same performance for the same pay level as the Owner.

Normalization of the Taxpayer’s financial performance to align with the industry would provide a reasonable estimate of market compensation for the Owner. In normalizing the Taxpayer’s performance, the Taxpayer’s ordinary business income is reduced to align with the industry. The amount of reduction is added to the Owner’s reported compensation as additional remuneration for the Owner’s services for the tax year 2020 below.

As produced by the IRS


As reported As normalized
2020 2020
Gross Receipts 2,828,727 2,828,727
Owner’s compensation deduction 116,192 2,387,446
Ordinary Business Income 2,624,758 441,281
The amount available to Owner as
compensation and distributions 2,740,950 2,740,950
Gross Receipts 100% 100%
Ordinary Business Income 92.8% 15.6%
RMA data related to NAICS 713290 2020 03
Sales 100%
Profit before Taxes 15.6%
IRS Conclusions
  • The reported compensation deduction for the Owner is understated for each of the two years under audit.
  • Based on the requirement that the reported compensation is reasonable, the Owner’s payment for services deduction is estimated at $2,599,587 for FYE 2019 and $2,387,446 for FYE 2020.
  • The effect of the revision of the reported compensation is summarized in Exhibit E. Effect of modification of the reported salary for the Owner.
Owner’s reported compensation 2019






Compensation deduction allowance for the Owner’s services 1,838,994 2,599,587 2,387,446
Increase in compensation allowance for the Owner’s services 1,711,794 2,472,387 2,271,254
Reported Ordinary Business Income 2,234,665

(As filed)


(As revised)

Reduction in Ordinary Business Income 1,711,794 2,472,387 2,271,254
Adjusted Ordinary Business Income 522,871 641,565 353,504
My prevailing conclusions:
  • The reported compensation deduction for the Owner is understated for each of the two years under audit.
  • Based on the requirement that the reported compensation is reasonable, the Owner’s payment for services deduction is estimated at $1,599,587 for FYE 2019 and $1,387,446 for FYE 2020.
  • Bottom line – Medicare tax on $1 M earnings for each tax year was clawed back to avoid Tax Court, and everyone smelled like roses.

Please reach out today for more on reasonable compensation and the S Corp owner.


1 Taxpayer’s response to Information Document Request Eng-2.

2 Ibid.

3 Taxpayer’s response to Information Document Request Eng-5.

4 The North American Industry Classification System United States, 2017 Executive Vice President, Office of Management and Budget. Page 18.

Found at URL:

5 Form 1120S, US Income Tax Return for an S Corporation, Schedule B. Other Information. 2 a and 2 b. FYE 2019 and FYE 2020.

6 US Census. North American Industry Classification System (NAICS) definitions. Found at URL: NAICS Search

7 US Census. North American Industry Classification System (NAICS) def1nit1ons. Found at URL: 2017 NAICS Search

8 Taxpayer’s response to Information Document Request Eng-1.

9 IRC, Sec. 162. Trade or business expenses. 162(a)(1)

10 Final Regulations, §1.162-7(a) – Compensation for personal services.

11 Final Regulations, §1.162·7(a)(3) • Compensation for personal services.

12 Elliotts, Inc. v. Commissioner, 716 F.2d 1241, 1245-1247 (9th Cir. 1983), rev. and remanding TC Memo 1980-282.

13 Occupational Outlook Handbook, Unites States Department of Labor, Bureau of Labor Statistics.

Found at URL:

14 Ibid.

I5 Ibid.

17 The Internal Revenue Service has paid for subscription access to the electronic version of Annual Statement Studies—financial Ratios Benchmarks from the Risk Management Association.

Found at URL: