For Sub-S owners, this issue isn't going away. Last year it even turned up in legislation, when the House passed a provision that would have subjected all profits of shareholder/employees of personal-service firms—such as accounting, law and consulting firms—to payroll taxes. The measure died in the Senate, but the IRS would likely welcome its return. Cases like Mr. Watson's are expensive for the agency to litigate because each turns on individual circumstances.
Recent IRS statistics suggest why the agency might focus on Sub-S pay. Over the past decade and a half, when executive paychecks exploded, the salaries of Sub-S owners declined as a percentage of total income, from 52% in 1995 to 39% in 2007, according to the latest data available. (The remaining income is taxable to the owners as well, but doesn't incur payroll taxes.) During the same 12-year period, Sub-S income doubled, while salaries increased only 26%. The average pay for a Sub-S owner was recently was $38,400, according to Martin Sullivan, an expert with Tax Analysts, a nonprofit publisher near Washington.
Tom Ochsenschlager, former head of tax for the American Institute of CPAs, says pay and payroll tax issues are a frequent source of friction with clients: "Sometimes you have to take them to the woodshed and say, 'You need to report more income as pay for personal services."'
What is a fair ratio of profits to pay? There isn't one answer, experts say. A company with substantial capital or assets, such as a manufacturer, often is able to justify lower pay than one selling personal services like a law or accounting firm. Says Mr. Willens: "I would tell a client that for personal services, 70% would be the absolute floor and might not get the job done," he says.
Read more about S corporation tax savings.