If you had to name a single disadvantage of an S corp, it would not be the payroll or the paperwork. It would be the reasonable compensation requirement, because that is the one that turns your own salary into a recurring audit question and quietly limits how much the election actually saves you. Every other disadvantage is a cost you can budget for. This one is a judgment call that the IRS reserves the right to second-guess years after you make it.
The appeal of the S corp is that distributions escape the 15.3 percent self-employment tax. The catch is that you only get there by first paying yourself a salary the IRS would call reasonable, and "reasonable" is not a number you control. It is a standard, applied with hindsight, that determines whether your savings hold up or collapse into back taxes and penalties. Understanding this single disadvantage tells you more about whether the election fits your business than any benefit ever will.
The Reasonable Compensation Rule Caps Your Savings
The entire S corp tax benefit lives in the gap between your salary and your distributions. Salary carries payroll tax under IRC § 3121. Distributions do not. So the bigger your distribution and the smaller your salary, the more you save. The obvious move is to pay yourself almost nothing and take everything as distribution, and the IRS closed that door decades ago.
Under the authority interpreting employment tax and reflected in rulings like Rev. Rul. 74-44, the IRS requires an S corp owner who works in the business to pay a salary that reflects reasonable compensation for the services actually performed. If you pay yourself below that level, the IRS can recharacterize your distributions as wages. The leading case, David E. Watson, P.C. v. United States, upheld exactly that result: an accountant who paid himself 24,000 dollars and took roughly 200,000 dollars in distributions had a large portion of those distributions reclassified as wages, with payroll taxes and penalties attached.
The practical effect is a ceiling on your savings that you do not get to set. If a reasonable salary for your role is 110,000 dollars and your business nets 140,000 dollars, only 30,000 dollars of distribution sits outside the self-employment tax layer. The higher your skill commands in the labor market, the more of your profit the IRS expects to see taxed as salary, and the smaller the slice the election can actually shelter. For many high-earning professionals, the reasonable compensation requirement is the disadvantage that makes the S corp less valuable than the marketing suggests.
The Standard Is Vague, Which Is the Real Problem
What makes reasonable compensation a genuine disadvantage rather than a simple rule is that the standard is deliberately imprecise. There is no formula in the Internal Revenue Code that tells you the right salary. Instead, the IRS and the courts look at a list of factors: your training and experience, your duties and time devoted to the business, what comparable businesses pay for similar services, the company's use of an independent compensation study, and the dividend or distribution history.
Because the standard is a multi-factor judgment, two reasonable advisors can land on different numbers for the same owner, and neither can promise the IRS will agree. You are making a decision today that an examiner can revisit three years from now with the benefit of hindsight and your full financials in front of them. That uncertainty has a cost even when you never get audited, because the prudent response is to document a defensible salary, often with a formal compensation study, which is an expense and an administrative burden that a default LLC never incurs.
The exposure is asymmetric, which is what makes it dangerous. Set your salary too high and you simply pay more payroll tax than you needed to, a modest and self-correcting mistake. Set it too low and you face reclassified wages, back payroll taxes, failure-to-deposit penalties, and interest, potentially across multiple open tax years at once. The downside of guessing wrong is far larger than the upside of guessing aggressively, which is exactly the kind of risk profile that should make an owner cautious.
The Disadvantage Compounds With Other Costs
The reasonable compensation problem does not sit alone. To pay yourself a salary at all, you have to run payroll, which means quarterly filings, withholding deposits, year-end W-2s, and a separate Form 1120-S return. That infrastructure exists primarily to support the salary that the reasonable compensation rule forces you to pay. In other words, the disadvantage creates a chain of secondary costs that all trace back to the requirement that you compensate yourself properly.
In California, the chain extends further. The state imposes a 1.5 percent franchise tax on S corp net income under California Revenue and Taxation Code section 23802, with an 800 dollar annual minimum, which a default single-member LLC does not pay. So the same election that requires the careful salary determination also adds a state-level tax on the profit that flows through. An owner focused only on the federal self-employment savings often forgets that the structure they are buying to capture those savings carries this recurring California cost on top.
There is also a rigidity cost that the reasonable compensation rule makes worse. Because the salary must track the market for your role, your tax position becomes sensitive to how your duties evolve. Take on more responsibility, and a defensible salary rises, shrinking the shelterable distribution. Step back from day-to-day work, and you have to be able to document why a lower salary is now reasonable. The structure asks you to keep justifying a number that keeps moving, which is a maintenance obligation that the simplicity of a default LLC avoids entirely.
Why This One Disadvantage Should Drive the Decision
If you are weighing whether to elect S corp status, the reasonable compensation requirement is the disadvantage to reason from first, because it determines whether the benefit even exists for you. For a business with a large gap between a reasonable salary and total profit, the election delivers real, recurring savings worth the compliance and the audit exposure. For a business where a reasonable salary consumes most of the profit, the savings are thin and the audit risk and California tax may not justify the structure at all.
It helps to see how the reasonable compensation disadvantage behaves at different income levels. At 120,000 dollars of profit with a reasonable salary of 60,000 dollars, half your income still escapes the self-employment tax layer, and the election looks attractive. At 120,000 dollars of profit where a reasonable salary for your role is 100,000 dollars, only 20,000 dollars sits outside that layer, and the audit exposure and California franchise tax may not be worth chasing it. Same profit, very different answer, driven entirely by what the market pays for your work. That is why the disadvantage is so individual: two businesses with identical revenue can land on opposite sides of the decision because their owners do different jobs. A generic calculator that ignores your actual role will quietly mislead you, in both directions.
That is the honest framing. The disadvantages of an S corp are not a reason to avoid the election. They are a reason to size it. And the single disadvantage that does the most to determine whether the election is worth making is the one that controls how much of your profit you are actually allowed to shelter: the requirement that you pay yourself a salary the IRS would defend, every year, with the burden of proof effectively on you.
Related reading: the disadvantages of an S corporation, the two main disadvantages of an S corporation, the downside of being an S corp, do you pay more taxes as an LLC or S corp. For the full practice overview, see our S-Corp Attorney page.
The reasonable compensation question is where good S corp planning either holds up or falls apart, and it is exactly the kind of judgment that benefits from a lawyer's eye rather than a generic calculator. Delina helps owners set salaries that capture the savings without inviting the audit.
If you're ready to build a defensible salary-and-distribution structure for your S corp, book a paid intake with Delina. This is not a free call. It is a focused, strategic session with an attorney who has read everything above and has specific opinions about your situation.
Ready to put this into practice? Tell us your situation.
Get Started →