S corporation shareholders who pay themselves distributions rather than reasonable compensation will be subject to increased audit risk in the future. S corporation shareholders receive profits from the business in the form of either wage income or distributions. Wage income is subject to employment tax. Distributions are not. S corporation shareholders have an incentive to receive income from the business as distributions rather than as wages. The IRS will recharacterize distributions from the S corporation if it believes that the shareholder is not paying herself reasonable compensation for any services that she provides to the business.

In a recent internal publication, the IRS revealed that it has started a compliance program to increase its examinations of this issue. This article first gives an overview of the reasonable compensation issue before turning to the IRS’ enforcement strategy.

Description of S Corporation Taxes

S corporations are “flow-through entities.” An S corporation’s income flows through to its shareholders – its income is not taxed at the entity level. S corporations are required to file income tax returns. But these returns are filed only to provide information to its shareholders and the IRS. S corporations generally do not pay tax at the S corporation level. Instead, S corporation shareholders report any income or losses on their individual income tax returns.

This can be contrasted with C corporations, which pay tax at the entity level. A C corporation first pays tax on its income. Then, distributions (from current or accumulated earnings and profits) to shareholders are taxed as dividends on the shareholders’ individual income tax returns. C corporations are subject to two levels of taxation.

S corporations are like sole proprietorship, general partnerships, and limited liability companies in that these business entities are subject to only one level of taxation. What distinguishes S corporations – and why they are often a preferred choice of entity for small businesses – is that income from S corporations can be structured to minimize federal employment taxes.

Federal employment taxes generally consist of federal Social Security and Medicare tax (or self-employment tax) and unemployment taxes. A small business owner who provides services for an S corporation is only subject to federal employment taxes on the wage income that the S corporation pays to her. If the S corporation has income after all expenses, including wages paid, such amount is not subject to employment tax. Instead, that income is only subject to income tax, and can then, generally, be distributed to the shareholder without incurring any additional taxes.

A simple example follows:

S corporation earnings before wages to shareholder:

$200

Wage paid to shareholder:

$100

Employee share of employment taxes:

$7.65

Employer share of employment taxes:

$7.65

Total employment taxes paid:

$15.30

The amount of S corporation earnings remaining after the wages and employment taxes are paid is $92.35. That amount is subject to income tax but not employment tax. And it can generally be distributed to the shareholder without incurring any additional tax.

Contrast this with a business operated as a single-member LLC (treated as a sole proprietorship for tax purposes):

LLC income:

$200

Employment taxes (as self-employment tax):

$30.60

Consider a final example, with the S corporation shareholder paying herself no wages but distributing all S corporation income to herself:

S corporation cash distributions to shareholder:

$200

Employment taxes:

$0

As reflected above, an S corporation, especially one with a single shareholder, can control the wages paid to its shareholder to minimize employment taxes. These are simple examples that only considers employment taxes (other considerations such as fringe benefits, deferred compensation, income taxes, Social Security benefits, etc. should play a role in choice of entity and compensation decisions). But it illustrates the general rationale for small businesses’ preference for the S corporation form.

S corporation shareholders therefore generally prefer distributions over wages. But the IRS’ position, which has prevailed in court, is that shareholders who provide services to the S corporation cannot pay themselves distributions in lieu of a reasonable wage compensation.

Consider the final example above. The sole shareholder is an accountant whose income source is accounting services that she provides through the S corporation. Her accounting services bring in $200 of profit for the S corporation. The S corporation then distributes that amount to the shareholder/accountant. She pays income tax but no employment tax on that amount. The IRS determines, after applying a facts-and-circumstances test, that the reasonable compensation of an accountant in the shareholder’s position would have been $100. That amount is recharacterized as wages subject to employment taxes. At a minimum, the shareholder/accountant will now receive a bill from the IRS for the unpaid employment taxes, penalties, and interest.

But note that reasonable compensation in this instance was not all the company’s profit. The tax law recognizes the S corporation as a separate entity. The shareholder/service provider wears two hats – that of an officer of the corporation providing services and that of investor seeking return on investment. Each is entitled to compensation from the profit of the business.

Reasonable compensation of the business owner in her role as an accountant is, in simplified terms, what that profit-motivated business would reasonably pay a similarly situated accountant for the services that she provided to it. The full test requires a consideration of eight factors (though these eight factors are described as nonexclusive!).

And recognize, the IRS can only recharacterize distributions made to the shareholder/service provider. If no distributions or other payments are made from the S corporation to the shareholder/service provider, there is no compensation for the IRS to recharacterize.

In short, S corporation shareholder/service providers are motivated to keep their wage compensation low. The IRS takes a dim view on this type of planning. As a result, this tax strategy is prone to IRS enforcement.

The IRS’ Review and Enforcement of S Corporation Reasonable Compensation

Most IRS reviews of S corporation returns are IRS field examination. These are commonly known as IRS audits. These examinations begin as a simple initial contact and request for documents. They can quickly expand to compelled disclosure of documents, third-party contacts, in-person interviews, and can result in serious legal consequences.

But the coverage rate for these field examinations is exceedingly low. Between 2017 and 2019, the IRS annually examined approximately 10,000 of the 5 million S corporation income tax returns filed (a .2% audit rate).

While some of these examinations are random, most are populated through the Discriminant Function (DIF) System. IRS algorithms analyze filed returns for tax underreporting using information gleaned from the processing of billions of tax returns over the years. Returns are then assigned DIF scores based on the potential for underreporting. IRS personnel then manually review the returns with the highest DIF scores, selecting some for examination.

Importantly, these individuals identify specific items on the selected returns for review. A field examination does not consist of a review of the entire filed return, but only the selected items that have the greatest potential for underreporting. An IRS examiner has limited time, which, in most instances, is focused on obtaining as much additional tax revenue as possible. Officer’s compensation was selected as an initial issue in only 14% of the S corporation field audits (of the .2% of S corporation returns selected for audit).

Note though, a revenue agent is not limited to the issues initially selected for review. If, during the examination, the agent discovers additional items on the return that may lead to changes, those items can be examined as well.

In addition to the field examination, the IRS has a unit dedicated to examining officer’s compensation of S corporations. This unit examines approximately 4,000 returns per year. These examinations result in average additional tax assessments of approximately $17,000 per return. When these examinations are added to the field examinations focused on officer’s compensation, approximately .1% of filed S corporation returns are examined for reasonable compensation issues (5,000 out of 5 million).

The IRS has indicated that it believes that its review of officer’s compensation associated with S corporations has been insufficient in relation to the potential issue. Between 2016 and 2018, the IRS identified 266,095 S Corporation returns showing profits greater than $100,000, a single shareholder, and no officer’s compensation. These returns reported profits totaling $108 billion and the shareholders took distributions totaling $69 billion. Because of how these returns were structured – showing profit but no officer compensation – the shareholders potentially reported and paid no Social Security and Medicare tax. The IRS estimated that this structuring helped those shareholders avoid paying $3.3 billion in such taxes.

Though note that wages paid to the shareholder could have been reported on the wage line rather than the officer’s compensation line. Lines 7 and 8 of the S corporation income tax return are for compensation of officers and salaries and wages, respectively. A shareholder/service provider should input wages paid to her on Line 7, compensation of officers. But she may, understandably, include such amount on Line 8, salaries and wages. The IRS’ analysis does not account for this likely explanation. Therefore, this analysis likely overstates the problem.

Regardless, the IRS believes that there is significant noncompliance in this area. It has recently initiated a “Compliance Initiative Project” focused on this issue. The goal of this project will be to change taxpayer behavior and bring attention to the issue of reasonable compensation of S corporations. As the IRS’ toolkit is limited, it will try to do this by increasing examinations of this issue. It is not stated how many additional examinations of reasonable compensation that the IRS will initiate going forward. But this project reflects that additional IRS resources are being focused on this issue.

The low level of audits in this area is likely, to some extent, related to the difficulty involved in reasonable compensation cases. What compensation is reasonable is determined through a facts-and-circumstances test, which contains at least eight factors. This does not lend itself to quick and easy examinations. These examinations require additional time and often the assistance of a compensation expert in the specific business sector. And the dollar adjustment will often be lower than an income tax audit as the employment tax rate is generally lower.

Because of the difficulty involved in these audits and the lower payoff (from the IRS’ perspective), IRS resources likely produce more of a dollar return being focused on other issues. But the IRS believes that this is an issue that needs correcting. Though recognize that the internal publication discusses low-hanging fruit – those returns which show distributions but no officer’s compensation.

Takeaways

• S corporation shareholder/service providers are often motivated to receive income in the form of distributions rather than wages. Doing so decreases the owners’ employment tax liabilities.
• The IRS will recharacterize S corporation distributions as wages if the S corporation shareholder/service provider is not paying herself reasonable compensation for the services that she provides to the S corporation.
• The IRS currently examines approximately .1% (1 out of 1000) filed S corporation returns for reasonable compensation issues.
• The IRS believes that its coverage is insufficient. The IRS has initiated a compliance program to increase examinations of the reasonable compensation issue. The IRS has not indicated how many additional examinations will result.
• To avoid a potential audit, take into consideration the reasonable compensation rules when designing your S corporation compensation.