IRS audit risk for S corporation reasonable compensation

Federal tax law recognizes S corporation officers, including owners active in day-to-day operations, as employees deserving reasonable compensation for their work. That reasonable compensation must be wages subject to Social Security, Medicare, and unemployment taxes.

S corporation officers avoid payroll tax by keeping their reported salaries lower (or not paying any salary at all), despite the legal requirement to reasonably compensate themselves.

A worst-kept secret within the tax professional community is that many S corporation owners pay themselves less than a reasonable salary or simply fail to pay themselves any salary.

The Internal Revenue Service (IRS) enforces federal tax law, including the reasonable compensation requirement for S corporations.

About a year ago, the Treasury Inspector General for Tax Administration (TIGTA) released a report on “Efforts to Address the Compliance Risk of Underreporting of S Corporation Officers’ Compensation.”

The report starts with a summary of 266,095 Forms 1120-S, or S corporation tax returns, processed during 2016–2018, that had the following characteristics:

• profits greater than $100,000,
• a single shareholder,
• no officer’s compensation claimed, but
• were not selected for a field examination.

In other words, these returns indicate profitable S corporations that did not pay owners reasonable compensation yet received no scrutiny from IRS. (For reference, IRS reported about 15 million S corporation returns filed during that three-year period.)

The returns collectively reported profits of $108 billion and distributions (not subject to payroll tax) of $69 billion. TIGTA estimates these returns should have included about $25 billion in reasonable compensation, resulting in $3.3 billion in unpaid Social Security tax.

IRS appears to allow quite a few S corporations with red flags to escape scrutiny. But what about those IRS does audit?

TIGTA reviewed 3,172 closed audits from 2016–2019 of S corporations that reported a single shareholder, gross revenue of $250,000 or more, but no officer’s compensation.

IRS did not determine officer compensation an issue in 1,406 (or 44.3 percent), despite meeting their own criteria of “high risk."

To summarize, IRS does not audit many S corporation return (about 1%). When IRS does audit high risk returns, it flags reasonable compensation as an issue less than half the time.

What does that mean for you? There is a big difference between avoiding the law getting lucky. You will never lose an audit by following the law.

Codes of ethics in my profession prohibit me from advising clients based on whether or not I think a return will be audited. I have to assume every return will be audited.

And I don’t like to lose.