Treasury Reg. 1.162-7: Reasonable Compensation Two-Part Test

Under Treasury Regulation 1.162-7, a salary, bonus, or other payment your business deducts as compensation must clear two hurdles: the amount has to be reasonable for the work, and the payment has to actually be for services the recipient performed. That two-part rule is the reasonable compensation standard, and it comes from IRC 162(a)(1), which allows a deduction only for a “reasonable allowance for salaries or other compensation for personal services actually rendered.”¹ When either half fails, the IRS can strip the deduction and relabel the payment as something else — usually a disguised dividend in a C-corporation, or disguised wages in an S-corporation.

What the Two-Part Test Actually Asks

The first prong is about the number. Total pay has to be comparable to what other businesses pay for similar work, performed by similarly qualified people, under similar conditions.² The second prong is about intent. The money has to be paid for work, not as a way to move profits out of the business under a wage label.

The purpose prong matters most in closely held businesses, where the person setting the salary and the person receiving it are the same. The regulation looks past what the company calls the payment and asks what it was really for. A payment labeled “salary” that functions as a profit distribution loses the deduction no matter what the dollar figure is.³

How “Reasonable” Gets Measured

There is no formula. Courts and IRS examiners weigh a cluster of factors, and the IRS Reasonable Compensation Job Aid lists the ones examiners rely on most.⁴

What the employee actually does — duties, decisions, and responsibility carried day to day.
Time committed to the business, including whether the person also works elsewhere.
The size and complexity of the business, because larger operations justify heavier pay.
Comparable pay for equivalent roles at similar companies in the same industry and region. This is what the IRS calls the market approach, and it is the agency’s preferred benchmark.
The employee’s professional background, expertise, and track record.
Internal consistency — whether the salary fits the pattern across the rest of the organization.
Whether the pay was set through genuine bargaining, or simply dictated by the person receiving it.

No single factor decides the case. A founder working 80-hour weeks at a young company can justify higher pay than the same title at a mature firm, provided the business can afford it. Weakness in one area, such as the absence of arm’s-length bargaining when an owner sets their own salary, has to be offset by strength elsewhere — strong comparables, documented results, a coherent internal pay structure. Examiners are building a composite picture, not scoring a checklist.

The Independent Investor Angle

Some circuits apply an additional test that comes at the question from the other direction. The independent investor test, developed by the Seventh Circuit in Exacto Spring Corp. v. Commissioner, asks whether a hypothetical outside investor would be satisfied with the return the company delivers after paying the salary. If the business earns a return on equity at or above what investors in similar companies would expect, the compensation is presumptively reasonable, because no rational investor complains about a high salary while still getting a strong return.⁴

The logic runs in reverse too. When return on equity falls below industry benchmarks after the executive’s pay, the gap suggests the salary is carrying disguised dividends. One caveat matters: the strong return has to trace back to the employee’s work. Windfalls from favorable markets or a one-time asset sale do not count in the executive’s favor.

Where the Risk Sits Depends on Your Entity Type

C-Corporations: Paying Too Much

C-corporation profits get taxed at the entity level and taxed again when distributed as dividends. Salary is deductible, so inflating executive pay is a way to move money out of the company while avoiding the second layer of tax.¹ That is exactly the situation the reasonable compensation rule was built to police.

When the IRS reclassifies excess pay as a constructive dividend, the outcome is worse than if the company had just paid a smaller salary and declared a dividend openly. The corporation loses the deduction on the excess, its taxable income goes up, the recipient still owes tax on the full payment, and the excess is now subject to dividend treatment on top of that. The owner ends up double-taxed on money the corporation can no longer deduct.

S-Corporations: Paying Too Little

S-corporations run into the opposite problem. Because income passes through to shareholders without entity-level tax, the tax advantage of taking distributions instead of salary is avoiding employment taxes. The combined Social Security and Medicare rate is 15.3% on wages, split between employer and employee, with the Social Security portion applying to wages up to $184,500 in 2026.⁵ Distributions carry none of that. An owner paying themselves a $30,000 salary while taking $200,000 in distributions is trying to skip a meaningful tax bill.

The IRS has won this fight repeatedly. In Veterinary Surgical Consultants, P.C. v. Commissioner (2001) and Joseph M. Grey Public Accountant, P.C. v. Commissioner (2002), the Tax Court reclassified distributions as wages where owner-employees were performing substantial services and paying themselves little or nothing.⁶ The agency’s position: if you receive cash or property from your S-corporation and you work for it, the corporation must determine and report a reasonable salary for you.

When distributions get reclassified, the fallout goes beyond the employment taxes themselves. The corporation owes the employer’s share of FICA plus interest from the original due date. Failure-to-deposit penalties and failure-to-file penalties for the Forms 941 that should have been filed can also apply, and the lookback can span multiple years.⁷

Bonuses, Profit-Sharing, and Catch-Up Pay

The form of a payment does not decide whether it is deductible. A bonus is not automatically suspect, and a flat salary is not automatically safe.³ Contingent arrangements hold up best when the deal was struck before the services were performed, not decided at year-end after the profits were known, and when the employer’s motivation was securing services on fair terms rather than distributing earnings. A profit-sharing formula agreed to in advance and at arm’s length is generally deductible even if the eventual payout is larger than anyone expected, as long as total compensation stays inside the reasonable range.

Timing matters. Reasonableness is judged against the circumstances that existed when the compensation agreement was made, not when the IRS later reviews it. A bonus formula that looked reasonable in January does not become unreasonable because the year turned out well. A year-end bonus decided after profits are already on the books, with no pre-existing plan, invites the IRS to call it a dividend.

Catch-up pay for founders and key employees who accepted below-market pay during a company’s early years is deductible in the year it is paid. The Supreme Court settled that point in Lucas v. Ox Fibre Brush Co., holding that the statute does not require the services to have been performed in the same tax year, only that the payment be a reasonable allowance for services actually rendered.⁸ The catch is proving that intent. Without contemporaneous records showing the current-year payment was meant to make the employee whole for prior underpaid work, the IRS measures the whole amount against a single year’s services, and a figure that would be reasonable spread across five years looks excessive against one. Board minutes and written agreements documenting the deferred compensation plan are what carry the argument.

Family Employees

Salaries paid to a spouse, child, or other relative face heightened scrutiny because the family relationship replaces the arm’s-length bargaining that normally holds pay in check.² The relationship does not make the pay automatically unreasonable, but it does raise the practical burden. Examiners look at whether an outsider could have done the same job at a lower cost, and abrupt raises that track a family member’s growing influence rather than any new responsibility are a red flag. Detailed records of hours, duties, and market rates carry extra weight here, because the arm’s-length defense is off the table.

Consequences When the IRS Wins

Losing a compensation challenge costs more than just the deduction. The disallowed portion increases taxable income, which produces additional tax plus interest running from the original due date. On top of that, the IRS can impose a 20% accuracy-related penalty if the underpayment resulted from negligence or a substantial understatement of income.⁹

For an S-corporation with reclassified distributions, add the employer’s share of Social Security and Medicare, deposit and filing penalties on the missing employment tax returns, and interest on all of it. For a C-corporation, the reclassified excess is a constructive dividend: no deduction for the company, and the shareholder can end up owing dividend-rate tax on money already taxed as wages.

Two boundary points worth knowing. Publicly held corporations face a separate ceiling under IRC 162(m) that disallows any deduction above $1 million per year for a “covered employee,” and that limit applies whether or not the pay would clear the reasonableness test. Tax-exempt organizations operate under a different regime entirely: IRC 4958 imposes excise taxes on excess benefits paid to disqualified persons rather than adjusting a deduction the nonprofit does not take.¹⁰

Building a Defensible Compensation File

Because the IRS runs on a market approach, the strongest defense is data showing your pay lines up with the market. The IRS Job Aid lists the kinds of evidence examiners find credible:⁴

General industry salary surveys keyed to SIC or NAICS codes, showing pay ranges for comparable positions.
Industry-specific reports from trade groups or analysts covering your sector.
Public company filings, including proxy statements and annual reports that disclose executive pay.
Private company data from commercial compensation databases.

Internal documentation counts too. Board minutes should record what comparables the directors reviewed, what factors they weighed, and why they landed on the number they did. Written job descriptions that spell out responsibilities, authority, and time demands give the dollar figure its context. A formal compensation study from a consultant is not required, but one creates strong evidence of good faith if the number is later challenged.

Businesses that set pay without any documented process are the ones that lose. The IRS is not looking for perfection, only for evidence that someone made a deliberate, informed decision. Cases with no paper trail draw the pursuit; cases where the business made a good-faith effort and landed slightly above market usually do not.

1
Office of the Law Revision Counsel. 26 USC 162 – Trade or Business Expenses
2
Internal Revenue Service. 1993 EO CPE Text – Reasonable Compensation
3
eCFR. 26 CFR 1.162-7 – Compensation for Personal Services
4
Internal Revenue Service. Reasonable Compensation Job Aid for IRS Valuation Professionals
5
Social Security Administration. Contribution and Benefit Base
6
Internal Revenue Service. S Corporation Employees, Shareholders and Corporate Officers
7
Internal Revenue Service. Wage Compensation for S Corporation Officers
8
Justia. Lucas v. Ox Fibre Brush Co., 281 US 115 (1930)
9
Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments
10
Office of the Law Revision Counsel. 26 USC 4958 – Taxes on Excess Benefit Transactions