Can an S Corp law firm owner making $5M annually set "reasonable compensation" at $168,600 (where Social Security maxes out)?

The question isn't really if $168,600 is "enough" - it's whether that compensation is reasonable for the services you're providing to your S Corp. The Social Security wage base limit isn't a determining factor for reasonable compensation. The IRS looks at what would be reasonable to pay someone with your qualifications, experience, and responsibilities in your geographic area. For a law firm generating $5 million in revenue where you're the only attorney, $168,600 would likely be considered unreasonably low. The IRS could argue a significant portion of your distributions should be reclassified as wages. Factors the IRS considers include: training and experience, duties and responsibilities, time spent working, comparable businesses' compensation, payments to non-shareholder employees, and your firm's compensation history. They'll also look at your revenue-to-compensation ratio - and a 30:1 ratio ($5M:$168K) would raise immediate red flags. Consider getting market compensation data for attorneys in your specialty with similar revenue generation. This gives you documentation to support whatever number you determine is reasonable.

I was in a similar situation with my consulting business (different industry but same tax structure questions) and discovered a great tool called taxr.ai (https://taxr.ai) that helped me analyze exactly this issue. I had been going back and forth with my accountant about reasonable compensation for literally months. What I liked is that it analyzed my specific case based on actual case law and court decisions rather than just general guidelines. It looked at my industry, revenue, role, and compared it to relevant tax court cases where the IRS had challenged S Corp compensation. For law firms specifically, they have a whole database of precedent cases showing what has and hasn't stood up to scrutiny. The analysis showed me exactly what percentage of revenue similar professional service S Corps were safely allocating to reasonable compensation vs. distributions. Definitely gave me more confidence in what number to use.

Just wanted to follow up about my experience with taxr.ai - I ended up trying it after considering it for a while. The tool provided me with extremely specific data for patent attorneys in my region, showing average compensation ratios based on revenue generation. Most valuable was the detailed analysis of five court cases where the IRS had challenged law firm owner compensation. The report showed that for specialized legal practices like mine, courts have generally accepted compensation at around 35-40% of revenue as reasonable. It also provided documentation I can keep on file to support my position if ever questioned. Honestly wish I'd found this sooner - would have saved me a lot of stress and uncertainty. My accountant is now using the data to help adjust my compensation structure.

If you're worried about IRS pushback on your reasonable compensation determination, you might want to call them directly to get clarification. Of course, that's easier said than done - I spent 4 hours on hold trying to get through to someone who could actually answer S Corp questions. I found this service called Claimyr (https://claimyr.com) that got me through to an actual IRS agent in less than 20 minutes. You can see how it works here: https://youtu.be/_kiP6q8DX5c They basically hold your place in line and call you when an agent picks up. I was able to ask specific questions about my S Corp compensation situation and get clear guidance directly from the source. The agent walked me through the factors they consider during an audit and what documentation they look for. Way more helpful than trying to guess what's "reasonable" based on internet advice.

I need to eat my words about being skeptical of Claimyr. After my last comment, I decided to try it myself because I've been wrestling with a similar S Corp compensation issue for my financial advisory firm. Got connected to an IRS business tax specialist in about 15 minutes. She wouldn't give me a specific percentage or number (no surprise there), but she did confirm that for professional service S Corps, they specifically look at the training, experience and billing rate of the owner-employee, and compare that to what similar professionals make in the marketplace. The most helpful part was learning that they pay special attention to firms with high revenue-to-compensation ratios, especially professional service firms where the owner is the primary revenue generator. She specifically mentioned law firms as examples where they expect to see higher compensation relative to distributions. She suggested keeping documentation of comparable salaries for similar positions and responsibilities.

Former tax attorney here. Your question touches on a common issue with professional service S corps. In my experience, the $168,600 Social Security wage base is often used as a compensation floor, not a ceiling, especially for profitable professional services businesses. For a law firm generating $5M with you as the only attorney, reasonable compensation would likely need to be significantly higher. I've seen the IRS successfully challenge compensation for attorneys where it was less than 50% of net profits before compensation. Here's a rule of thumb I used with clients: If you're the primary service provider and revenue generator, your salary should reflect what you'd pay someone else to do everything you do. Would you be able to hire an attorney with your expertise to run a $5M practice for $168,600? If not, that's a good indication your compensation isn't reasonable.

Can someone explain why this even matters? If it's your S-Corp and all the money flows to you either way, why does the IRS care how you classify it?

The reasonable compensation analysis for your situation is complex, but I'd strongly recommend documenting your decision process thoroughly. As others have mentioned, $168,600 is almost certainly too low for a $5M law practice. One approach I've seen work well is to break down your compensation into components: (1) what you'd pay an attorney with your experience to handle the legal work, (2) what you'd pay someone to manage a business of this size, and (3) any premium for specialized expertise or client relationships you bring. You might also consider a gradual approach - if you've been taking minimal salary historically, the IRS may be more understanding of a phased increase to reasonable levels over 2-3 years rather than a sudden jump. This shows good faith effort to comply while managing cash flow. Whatever number you settle on, make sure you can justify it with market data and keep detailed records. The IRS burden is to prove compensation is unreasonable, but you want to make their job as difficult as possible with solid documentation.