IRS Red Flags and Audit Methods for Reasonable Compensation.
- S Corp Expert
- Jun 5
- 4 min read
Updated: Jun 25
If you own an S corporation and are also actively involved in its operations, the IRS expects you to pay yourself reasonable compensation for the services you provide.
The IRS is aware of the game some CPAs play. Misclassifying compensation (as distributions instead of wages) results in underpaid payroll taxes. On the flip side, paying too much compensation shifts income among shareholders or converts taxable distributions into deductible wage expense, which affects things like qualified business income deduction, research activity credits, built-in gains tax, and passive activity rules.
The IRS is motivated to establish what constitutes reasonable compensation because, by doing so, they can assess payroll taxes or disallow certain credits and deductions.
But first things first:
How Does the IRS Distinguish Between Compensation and Distributions?
When reviewing a tax return, the IRS revenue agent looks at how the shareholder-employee contributed to the company’s profits. Generally, S corporation income comes from three sources:
1. Services provided by employees who are shareholders,
2. Services provided by employees who are not shareholders, and
3. Utilization of capital and assets of the corporation.
The IRS expects shareholder-employees to be compensated:
For directly generating gross receipts, and
For administrative or managerial tasks—like overseeing employees or managing assets—that support income production.
If the shareholder is one of several highly skilled workers, their salary should generally be comparable to others doing similar work—unless they have added responsibilities (like executive or managerial duties) that justify higher pay. (See: Pediatric Surgical Associates, T.C. Memo 2001-81)
However, payments based on profits earned through other employees’ work or through the corporation’s assets are considered returns on investment. These should be classified as distributions, not wages.
How Does the IRS Decide If Compensation is Reasonable?
The IRS doesn’t use a fixed formula. Instead, it follows a facts-and-circumstances approach, based on guidance from Mayson Manufacturing Co. v. Commissioner.
That case outlined nine factors the IRS looks at:
1. The employee’s qualifications;
2. The nature, extent and scope of the employee’s work;
3. The size and complexities of the business;
4. A comparison of salaries paid with the gross and net income of the business;
5. The prevailing general economic conditions;
6. Comparison of salaries with distributions to stockholders;
7. The salary policy of the taxpayer as to all employees; and
8. The employee’s compensation in previous years
9. Typical compensation for similar roles in similar companies
To assess the factor number 9, revenue agents often use data from compensation research websites listed below. This means that taxpayers and their CPAs are allowed to use the same sources.
What Triggers IRS Concern About Too Little Compensation?
IRS auditors begin their audit by reviewing Line 7 of form 1120S, which reports officer compensation. What is the major red flag? When this line shows very low—or zero—wages, but at the same time:
• Large distributions are reported on Schedule K, Line 16d, and/or
• The Balance Sheet (Schedule L, Line 7) shows increases in shareholder loans
In these cases, the IRS may suspect an attempt to avoid payroll taxes by treating wages as tax-free distributions.
But the IRS won’t automatically label the compensation as “too low.” First they will make sure that the following three conditions are met:
The shareholder must be an employee under IRC § 3121(d)
A payment must actually have been made
A reasonable salary should have been established under IRC § 162(a)(1)
If any of these conditions aren’t met, The IRS won’t pursue the issue of low compensation . That’s because there’s no requirement that a corporation must pay its shareholder-employees. But if it does pay them, those payments must meet the standard of “reasonableness.”
What About Excessive Compensation?
Screening for excessive compensation, the revenue agent will look at the same Line 7 and see if the officer salaries are so high that they eliminate taxable income and the corporation would otherwise be subject to the Built-in Gains Tax, or Beginning AAA is negative and the corporation appears to have AE&P.
The IRS may suspect the S Corp owner is using inflated compensation to manipulate tax outcomes. Common motivations include:
1. Inflated Qualified Business Income Deduction (QBID)
2. Avoidance of built-in gains tax
3. Recharacterization of taxable dividends into deductible wages
4. Income shifting among shareholders
5. Attempts to meet material participation rules for passive activity losses
6. Maximizing retirement plan contributions
7. Paying family members with little involvement in the business
8. Increasing wages to claim R&D credits
What do the Courts say About Excessive Compensation?
In evaluating excessive compensation, the tax court (Pediatric Surgical Associates, T.C. Memo 2001-81) said that:
The amount of the payment must be reasonable in relation to services performed, and
the payment is, in fact, intended as compensation for services rendered.
In other words, compensation will be excessive only if it is established that payments to a shareholder-employee were for something other than his or her services rendered, such as sharing of profits generated by services rendered by other employees or capital investments.
Final Thoughts: Because the IRS screens tax returns for both high and low numbers of shareholder compensation, it is important to remember that reasonable compensation is determined by services provided and only when actual cash movements between the S Corp and its owner did take place.
