S-Corporations and Reasonable Compensation: Best Practices for Avoiding IRS Audit Red Flags

With the extension season here and the closing window for end-of-year tax planning just around the corner, now is a critical time to review with any clients who have S corporation entities the importance of reporting accurate, reasonable compensation on their tax returns.The IRS has publicly stated that S corporation owners will be subject to closer scrutiny and any red flags on corporate and individual returns in general. This applies especially to those returns that raise concerns regarding overreporting or underreporting of compensation from a business entity. These scenarios on tax returns can become a slippery slope into a full-blown audit unless compliance rules are carefully followed.

Increased risk for S corporations

This is even more of a risk today than in the past. The IRS significantly increased its funding for compliance enforcement at the end of 2023, and the agency is focused on leveraging these resources to target S-corporation owners and other taxpayers.

To remain compliant with tax laws regarding S corporation owner reportable income, the rules related to reasonable compensation and its defensible calculation must be followed.

This fact is often unknown to the majority of S corporation owners. Even lesser known are the mechanics of calculating it accurately to the degree that it could be defended in the case of an IRS tax audit. Unfortunately, this lack of knowledge can leave clients (and uninformed tax practitioners) open to audit liability.

The IRS has been consistent in its intent to use its new wave of funding to increase enforcement, particularly among high-net-worth individuals and complex pass-through entities such as partnerships and S corporations. As such, using the extension season and year-end planning period to start preparing to potentially defend these clients from reasonable compensation and payroll tax audits is a proactive way to raise your value as a trusted advisor in your client’s eyes.

S corporation best practices for avoiding IRS tax audits

Consider the following best practices to help your S corporation clients avoid potential IRS tax audit red flags:

Double-check payroll taxes with accurate, reasonable compensation calculations.

S corporation clients paying themselves via W-2 must complete a reasonable compensation analysis every year or risk having inaccurate payroll tax payments, which can be a source of audits on their own.

If the IRS is concerned about an S corporation client underpaying payroll, it may expand its investigation to involve current and past years’ compensation amounts. Be sure to calculate reasonable compensation accurately and keep that set of calculations with your work papers in case of future IRS tax audits.

Use a legal means of payment reporting and worker classification for S corporation shareholder-employees.

All employees of an S corporation must be paid via W-2, even if the amount owed in taxes is the same as what would be reported on a 1099. Otherwise, your S corporation clients may be subject to penalties for not reporting their salary on a W-2.

Ensure that S corporation shareholder-employees are receiving reasonable compensation before making distributions.

If you have clients who are S corporation owners who received distributions but have not paid themselves W-2 wages, their audit risk is extremely high. This breaks a cardinal rule of compensation for S corporation owners.

While you should do a reasonable compensation analysis regardless of the scenario, you should be especially vigilant if you encounter clients with inconsistent compensation practices or those claiming low or zero salaries for shareholder-employees or high-profit margins with minimal salaries paid to shareholder-employees.

Leveraging reliable software to create a defensible and detailed reasonable compensation analysis to substantiate the reported salary will help you lower the IRS tax audit risk and you can use this scenario to educate your client too!

Regularly review and adjust compensation for your S corporation clients.

As indicated above, there is a need for ongoing review and adjustment of total salaries and benefits (this is what the IRS will look at). Ensuring that compensation remains reasonable and justifiable is at the heart of looking at each client’s total compensation package including salary, benefits, and bonuses through the lens of a thorough job analysis.

Always document your supporting calculations for reasonable compensation.

Companies have the responsibility to demonstrate the reasonableness of the

S corporation owner’s compensation and the best way of doing so is with credible independent research and documentation that you can obtain using reasonable compensation software.

Using software such as that found at RCReports.com will ensure you are using accurate market data to drive your compensation decisions. The data will also include industry-specific compensation information that will allow you to substantiate the compensation levels on your client’s tax returns.

Extension season offers a window to correct and capture reasonable compensation reporting and revenue opportunities.

The good news is that the extension season and the tax planning season leading up to year-end represent the perfect window to fix errors related to reasonable compensation for S corporation owners. If you have clients who haven’t paid themselves W-2 wages or didn’t take reasonable compensation in years prior, take the time now to be prepared and be proactive before the tax return extension deadline is over.

Reiterate the importance of a well-reasoned and documented compensation approach with your clients.

The majority of S corporation owners are not familiar with reasonable compensation, much less the mechanics of calculating it accurately or in a manner that can hold up to increased IRS scrutiny. By educating your clients now you will cement your place as a trusted advisor and help them avoid red flags on their tax returns and in their business tax situation that may trigger an IRS tax audit.

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