IRS Red Flags and Audit Methods for Reasonable Compensation.
Updated: 20 hours ago
If you own an S corporation and are actively involved in its operations, the IRS expects you to pay yourself reasonable compensation (aka form W-2). Why? because the IRS wants to collect your self employment taxes (FICA and Medicare) and the only way they could receive their share of your self employment taxes is if you issue yourself a big fat W-2.
The IRS is aware of the game some of us play. No paying yourself high enough wages means less self employment taxes goes into the IRS pocket.
And that's why the IRS is motivated to establish what constitutes reasonable compensation for a tax payer. Because, by doing so, they can tell you how much your W-2 should be, and your self employed taxes will be calculated based on the size of your W-2.
In fact, the IRS has a specialized group of Revenue Agents who work only on reasonable compensation issues. These RAs interview taxpayers about their day-to-day responsibilities and compare those duties against industry job descriptions and salary data to make sure the owners didn't pay themselves a superficially low salary.
But first things first:
How Does an Audit on Reasonable Compensation Start?
The audit can start on the individual level, when a Revenue Agent notices that the S Corp owner does not show a W-2 from his S Corporation on his individual1040 return. In this case, the reasonable compensation audit will be a part of the individual tax examination and the computation of additional self employment taxes will be a part of the 1040 examination.
However, as I mentioned earlier, there is a specific group at the IRS that deals only with self employment tax issues. These folks do not look at the form1040 at all, and they make all of their adjustments and decisions on the level of the S Corp tax return 1120-S.
Self employment tax auditors begin their audit by reviewing Line 7 of form 1120S, which reports officer compensation. What is the major red flag they are looking for? They look at low or non existent wages, but at the same time S Corp tax return showing either:
• The tax return shows large distributions on Schedule K, Line 16d OR
• The Balance Sheet (Schedule L, Line 7) shows increases in shareholder loans
In these cases, the IRS suspects an attempt to avoid payroll taxes by converting wages to tax-free distributions or loans.
So, What if There are no or Minimum Wages Shown on the S Corp Tax Return?
Well, the IRS isn't allowed to label the owner’s compensation as "too low" right off the bat. Before making any sort of decision, the IRS must prove that all three of the following conditions are met:
The shareholder is an employee under IRC § 3121(d) (i.e., they provide substantial services to the business).
Cash or property was actually transferred from the S Corp to the shareholder’s personal account or for their personal benefit.
An established, reasonable salary was warranted under IRC § 162(a)(1) based on market standards for those services.
If even one of these three conditions is not met, the IRS cannot pursue a reasonable compensation adjustment.
Why?
No Employee Status:Â The shareholder may simply be a passive investor rather than an active employee. Investors are entitled to distributions and are not subject to W-2 requirements.
No Movement of Funds:Â The IRS can only reclassify funds as wages if a transfer actually occurred. Without a movement of funds, the money remains inside the S Corp bank account, meaning no taxable event or distribution took place for the IRS to recharacterize.
No Value Provided:Â If the business generated no profit or the owner provided no valuable services during that tax year, a zero-salary position is entirely justified.
How Does the IRS Decide What is Reasonable Compensation?
But lets say all of these conditions were met. The IRS caught you transferring big sums of money into your personal account while actively working on your S Corp business. What now? How does the IRS figure out the perfect amount of compensation? And here is the news: the IRS doesn’t use a fixed formula. Instead, the IRS 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.
How Does the IRS Distinguish Between Compensation and Distributions?
But wait, you say. Aren't S Corp owners also allowed to distribute some money as a return of capital? Are all money transfers from an S Corp to a personal account deemed to be wages on which we pay self employment tax?
Well, no. The IRS still needs to look at how the shareholder earned this income.
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)Â Â Â
However, if the shareholder receives profits derived from the work of other employees or from a return on previously invested corporate capital, those payments should be classified as distributions, not wages.
For example:Â Imagine a surgeon who owns an S Corp and spends 40 hours a week operating on patients. For those direct medical services, the IRS expects them to be paid a W-2 salary comparable to what a hospital would pay an employed surgeon.
However, suppose that same surgeon also invested $500,000 of their own money to buy high-tech surgical equipment, and they hired three other doctors to work for the practice. The profits generated by those other doctors and that equipment represent a return on investment and business growth - not the surgeon's personal labor. Therefore, those profits can be paid out as tax - free distributions (exempt from self-employment tax), while the surgeon's personal knife-skills remain tied to a W-2 salary.
So, only after establishing all of these facts, the Revenue Agent is allowed to move with their case and establish a particular number of reasonable compensation. But wait. what of the owner paid himself too much? This also happens and the IRS agents look out for these types of situations as well.
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.
