If Clary Hood is the modern excessive-compensation reference point, David E. Watson, P.C. v. United States, 668 F.3d 1008 (8th Cir. 2012), is its mirror image — the leading appellate decision on compensation that is too low. It remains the case every S corporation owner, CPA, and tax counsel should understand before setting shareholder-employee salary.

The facts were unhelpfully clean

David Watson was a CPA whose professional corporation — an S corporation — was a partner in an Iowa accounting firm. For the years at issue, Watson paid himself a salary of $24,000 while receiving distributions many times that amount from a practice generating well into six figures. The government reclassified a portion of the distributions as wages and assessed employment taxes accordingly. The district court agreed, and the Eighth Circuit affirmed.

How the number was actually set

What makes Watson instructive is the mechanics. The court did not simply declare $24,000 unreasonable and split the difference. The government’s valuation expert built a market analysis of what a CPA of Watson’s experience and role would earn — drawing on accounting-industry compensation survey data — and concluded reasonable compensation was approximately $91,000. The court credited that figure because it was anchored to independent market data for comparable services, not to the taxpayer’s preferences or the government’s revenue interest.

Three takeaways for owners and their advisors

First, the standard runs both directions. The same Treasury regulation that limits excessive compensation — the amount ordinarily paid for like services by like enterprises under like circumstances — sets the floor for S corporation owners who under-pay themselves to avoid employment tax. Distributions in place of market-rate wages invite reclassification, back payroll taxes, penalties, and interest.

Second, rules of thumb have no authority. No court has adopted a 60/40 split, a distribution ratio, or any fixed formula. Watson turned on survey data for comparable professionals — which is precisely why documented market analysis beats a heuristic in every forum from examination to trial.

Third, the expert’s data carried the case. As in Clary Hood, the credited opinion was the one grounded in defensible comparability. The lesson for planning is the same as for litigation: put an independent, documented analysis in the file when compensation is set, not after the notice arrives.

Where Grahall fits

We provide the market analysis Watson rewards — as pre-filing opinion letters and studies for owners and their CPAs, and as expert reports and testimony when an S corporation compensation dispute is already underway. Both engagements begin the same way: a conflicts check, party names only.

This article is general commentary on a published decision, not legal or tax advice for any specific matter.