S Corporations


Helping S Corporations avoid Unreasonable Compensation Audits

© 2015 American Institute of CPAs - All Rights Reserved.  Reprinted with permission from the June 2015 issue of Journal of Accountancy.

Find out what entries on Form 1120S may trigger these audits.

By Stephen D. Kirkland, CPA, CMC, CFC, CFF

Since compensation is subject to employment taxes (including Federal Insurance Contributions Act taxes) and distributions to shareholders are not, S corporation owners often reduce their compensation and increase their distributions.  Therefore, one of the IRS's hottest audit triggers for S corporations is insufficient compensation paid to shareholders.  By understanding how the IRS evaluates data on Form 1120S, U.S. Income Tax Return for an S Corporation, and preparing accurate tax returns, CPAs can help these companies reduce their chances of being audited.

IRS audits of S corporation income tax returns can result in an increase in the payroll taxes the corporation owes, as well as interest and penalties. In response, owners want CPAs to carefully avoid the red flags that trigger these audits.

Use these nine steps to help S corporations reduce the likelihood of an IRS examination.


Tax return preparers must be careful to know who the shareholders are, so that Schedules K-1, Shareholder's Share of Income, Deductions, Credits, etc., can be prepared correctly.  But preparers also need to identify all of the officers, including any who may consider their ownership interest in the company to be an interest in a passive activity under Sec. 469 (the passive activity loss rules).

On Form 1120S, line 7 on Page 1 asks for the total amount of compensation paid to officers.  (Form 1120S does not ask for the amount of shareholder compensation, which is ironic since the IRS is looking for underpaid shareholders, not underpaid officers.)  Since the officer group may include employees who are not shareholders, total officer compensation may exceed total shareholder compensation.  In that case, putting the lower total shareholder-officer compensation on line 7 may cause that return to be pulled for examination under the assumption that active shareholders were underpaid.


Be sure that the correct business activity code is shown on Page 1 of Form 1120S each year.  Businesses change their activities over time, and the prior year's code may no longer fit.  The code shown on the return may lead the IRS to make assumptions about how much officers should have been paid.  For example, a corporation that has become inactive or simply owns vacant land may not be expected to pay any officer compensation.  But it would be a red flag for a return to show the code of a professional service firm or other active business while officer compensation expense on Page 1 of Form 1120S is zero (see, e.g., Sean McAlary Ltd., Inc., T.C. Summ. 2013-62 (S corporation reporting NAICS Code 531210, real estate agent/broker, not permitted to report no compensation paid to sole shareholder who was also company's only licensed real estate broker)).

If an S corporation conducts more than one trade or business, a primary business activity code needs to be selected.  In addition, the instructions to Form 1120S now state that companies with more than one trade or business should provide shareholders the information they need to correctly apply the passive activity limitations.  Therefore, supplemental schedules may need to be attached to the returns to break out income and expense information for the various lines of business.  This information also helps when determining compensation amounts for shareholders who provide varying levels of services to the different business activities.


Take care when showing the "Percent of time devoted to business" for each officer.  If an S corporation has total receipts of $500,000 or more, these percentages must be reported on Form 1125-E, Compensation of Officers, which is attached to Form 1120S.  Remember that taxpayers have the opportunity and the obligation to complete and file accurate tax returns.  Once a return is filed showing certain percentages of officers' time devoted to a specific business, the IRS may hold the S corporation and its shareholders to those percentages when comparing the pay levels of the S corporation's officers to those of other officers in the same industry.

This may lead to adverse adjustments when returns show higher percentages of time devoted to the business than shareholder-officers actually provided.  For example, a shareholder-officer spending only 30% of his or her time at one company would not want his or her pay to be evaluated as if he or she was an officer who spent 80% of his or her time on that business.

For any shareholder, the percentage may change significantly from one year to the next, especially for those who split their time among multiple entities.  Therefore, return preparers cannot blindly rely on percentages that roll forward from the prior year's tax return.


Do not take conflicting positions on corporate and personal tax returns.  For example, it could be hard to explain why an S corporation's return shows little or no compensation to shareholders who did not treat their S corporation interest as a passive activity on their Form 1040, U.S Individual Income Tax Return.

Also, an S corporation shareholder's occupation shown next to the signature on Page 2 of the personal income tax return should be consistent with the shareholder's position on whether the S corporation is a passive activity or with the amount of compensation the S corporation paid the shareholder.  It looks odd for a shareholder to be an "Executive" who treats his or her interest in the S corporation as a passive activity and receives no compensation from the S corporation.

The occupation shown on a shareholder-employee's Form 1040 should be broad enough to cover that person's multiple duties without overstating his or her responsibilities.


Clients need to be reminded that paying some payroll taxes may be costly, but it is certainly less time-consuming than being audited.

Also, practitioners should explain to shareholder-employees that, by taking salaries, they can fund their own retirement plans.  Once an IRS auditor has recharacterized distributions as wages, it is too late to make a deductible contribution to a retirement plan.  In addition, by being treated as employees, shareholders may be included in benefits the corporation provides to other employees.


Ongoing documentation of employee-shareholder participation is important.  Each shareholder has the burden of proving what services the shareholder provided and how much time was spent on each job.  Neither the IRS nor the Tax Court accepts after-the-fact guesstimates or verbal explanations (see, e.g., Midwest Eye Center, S.C., T.C. Memo. 2015-53).  The records should show specific services that the shareholder performed and how much time was devoted to each service.  Although most shareholders do not like the burden of keeping contemporaneous logs, this documentation will be crucial in the event of an audit.

The logs may be in the form of calendars, spreadsheets, or written narratives. In addition, corroborating evidence substantiating the shareholder's logs is required.  This evidence should include letters, emails, and other written documentation showing that a shareholder performed the services.  Also, practitioners should remind their clients that IRS auditors look for evidence that contradicts these logs, such as titles used on business cards, websites, and social media.


Unless he or she can provide compelling evidence to the contrary, any officer providing more than minor services to the corporation will be treated as an employee for payroll tax purposes (Sec. 3121(d)(1)).  Also, any distribution to a shareholder may be treated as compensation for services rendered unless the company provides evidence that it paid the shareholder reasonable compensation (see Glass Blocks Unlimited, T.C. Memo. 2013-180).

Shareholders should know which method of determining reasonable compensation will likely be used by the IRS or the courts to determine whether their compensation is reasonable.  The two primary methods are the multifactor approach and the independent investor test.

 Multi-factor Approach

This approach evaluates various key factors.  No precise list of factors exists, so the number of factors considered and the weight put on each factor vary from one case to another.

Often, the most important factor is the source of the company's gross revenue.  To the extent that revenue was generated by the shareholder's personal services, payments to the shareholder may be treated as compensation.  To the extent that revenue was generated by the work of nonowner employees and/or equipment and other assets, shareholder payments may be profit distributions.  However, significant administrative services shareholders provided are expected to be compensated, even though those services may not directly generate revenue.

Other key factors often considered are:

  • The officer's qualifications, including training and experience;
  • The nature, extent, and scope of the officer's duties and responsibilities;
  • The time and effort devoted to the business;
  • Compensation amounts paid to key employees who are not shareholders;
  • Timing and manner of paying bonuses to key people;
  • Compensation amounts paid for comparable services by similar companies ("comparability data");
  • The correlation between each officer's compensation and stockholding percentage;
  • The size and complexity of the business;
  • Prevailing economic conditions;
  • Compensation agreements;
  • The method or formula the company used to determine compensation;
  • The wording used in references to the payments on the company's books and records; and
  • The company's financial performance (see Mayson Mfg. Co., 178 F.2d 115 (6th Cir. 1949), and Choate Construction Co., T.C. Memo. 1997-495).

Although the multifactor approach attempts to consider all the facts and circumstances, it does not actually quantify the value of an officer's services.

 Independent Investor Test

This test considers the return on investment (or return on equity) that a hypothetical investor would have received after all compensation had been paid. For this purpose, the shareholder-officer is viewed as two people - an owner and a worker.  If that hypothetical owner's return on the investment in the company was similar to returns produced by comparable companies, this may suggest that the shareholder-officer was properly compensated (see Choate Construction Co., T.C. Memo. 1997-495, and Mulcahy, Pauritsch, Salvador & Co., Ltd., 680 F.3d 867 (7th Cir. 2012)).

The use of these two methods varies from one federal district court to another.  Regardless of which methodology is used, the IRS and courts carefully consider compensation comparability data during their analyses.


These data may come from a survey or database that compiles actual compensation amounts other companies paid, preferably in the same industry and the same geographic area.  The salary information must be reliable, so practitioners should go beyond whatever can be found free online.  Services are available that provide reliable data online at nominal cost, and the IRS extracts data from thousands of filed tax returns.  These data are available at irs.gov.  These are raw, unadjusted data, but they give an idea of how much other shareholder-officers chose to pay themselves in earlier years.

The positions used for comparison should be sufficiently analogous to the shareholder's position in the company. However, it is not always necessary for a shareholder to be paid within the range of comparability data.

Some shareholders' services may be poor or of limited use and therefore deserve pay below the normal ranges.  A few outstanding performers may deserve pay above the normal ranges, however.  If the company has those types of shareholder-employees, be prepared to explain why compensation was paid outside the normal range and prepare good documentation to support that position.  Although the IRS rarely argues that an S corporation shareholder was overpaid, it does happen (see Davis, T.C. Memo. 2011-286).

Since S corporations are required to make pro rata distributions to shareholders based on ownership, one shareholder's excessive compensation could be recharacterized as a distribution.  When that happens, the distributions become disproportionate, which in turn could cause inadvertent termination of S status by creating more than one class of stock (Regs. Sec. 1.1361-1(l)(1)).  (Disproportionate distributions may also violate state securities laws.)


Schedule L, "Balance Sheets per Books," on Form 1120S calls for balance sheets as of the beginning and end of the year.  The total amount of company loans to shareholders is shown separately on line 7.  The IRS examines these loans to see whether they are really disguised compensation, especially when loans remain unpaid for more than a year.


Although many S corporations are small businesses, the tax rules that apply to compensation of their shareholder-officers are far from simple.  These companies need proactive and comprehensive advice from their CPAs to ensure compliance, minimize taxes, and avoid red flags.  The nine items discussed above will go a long way toward helping S corporations file their returns to achieve the best results.

About the Author:  Stephen Kirkland is a compensation and financial consultant with Atlantic Executive Consulting, LLC.

(Un)Reasonable Compensation and S Corporations

When shareholders take funds out of their S corporations, they need to carefully classify each transfer as either compensation for services rendered or a distribution.  Many S corporation shareholders try to take large cash distributions but no compensation, since only compensation is subject to payroll taxes and withholding.

The Internal Revenue Service may examine these corporations and make what is referred to as a re-determination of worker classification.  This means that the IRS informs the corporation that they have determined that a shareholder should have been classified as the corporation's employee for federal employment tax purposes.  As a result, the IRS will assess liabilities for Federal Insurance Contributions Act (FICA) taxes, plus interest and penalties.

If they disagree, the shareholders need to be well prepared to respond to the IRS's re-determination.  The taxpayers bear the burden of proof.


An S corporation may own equipment or investments and/or operate a business.  Some individuals own multiple S corporations.  At many of them, the shareholders are responsible for operational and financial decisions and may perform most of the work necessary to run the business or to manage the corporation’s assets.

If the corporations take the position that the shareholders are not employees, and there are no other employees, the corporations may not bother to file IRS Form 941 (Employer's Quarterly Federal Tax Return) each quarter.  In addition, the companies may not see a need to issue Forms W-2 (Wage and Tax Statements) or Forms 1099-MISC (Miscellaneous Income) to the shareholders.

However, showing little or no officer compensation expense on page one of Form 1120S can be a red flag.  The IRS routinely conducts employment tax audits of S corporations for this reason.

A company may disagree with the auditor’s redetermination, and if no agreement can be reached at appeals, the U.S. Tax Court may be asked to decide whether the IRS's determination of worker classification is correct and to decide the proper amount of employment tax, including additions to tax and penalties.  This is an expensive and time-consuming process.

Employment Taxes

Internal Revenue Code Sections 3101 and 3111 impose FICA taxes on wages received with respect to employment.  The FICA tax comprises a 12.4% Social Security tax and a 2.9% Medicare tax.  This Social Security tax applies to wages up to an annual limit and the Medicare tax applies to all wages. One half of the FICA tax is imposed on the employer, by Section 3111, and the other half on the employee, by Section 3101.  An additional 0.9% Medicare surtax now applies to wages above certain levels.

Section 3102(a) requires an employer to withhold from wages the amount of the tax imposed on its employee.  Section 3102(b) says the employer is liable for remitting the tax it is required to withhold.

For employment tax purposes, Section 3121(a) defines wages as "all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash," with certain exceptions.

Regardless of how an employer characterizes payments made to a shareholder, the critical fact is whether a payment is actually received as remuneration for employment.  Therefore, an employer cannot avoid employment taxes by characterizing payments to its shareholder as dividends, rather than wages, if such payments are for services rendered. See Section 31.3121(a)-1(c), Employment Tax Regulations.

An officer who performs more than minor services for a corporation and who receives compensation in any form for those services is considered an employee, and his or her wages are subject to employment taxes.  See Section 3121(d)(1) and Section 31.3121(d)-1(b), Employment Tax Regulations.

What Should S Corporation Shareholders do During an IRS Audit?

The company may contend that re-characterizing distributions from the corporation to the shareholder as wages would create unreasonable compensation to him or her.  Yet, if a shareholder wants to justify receiving little or no compensation, it can be difficult to prove that he or she did no work, or performed only minimal and undemanding duties for which no training or special skills were required.  But there are a few steps that can help.

First, get good representation.  Engage a proactive tax attorney.  Attorneys with tax controversy experience can provide wise counsel and move the process along.

Second, maintain credibility in all dealings with IRS officials.  Be cooperative, provide reliable information and do not let emotions override common sense and professional advice.

Third, shareholders should be careful when telling IRS auditors what they accomplished.  Some executives have boasted about all they had done before realizing that their compensation would be an issue.

Fourth, be ready to provide compensation comparability data.  This data can be internal or external. Internal data includes evidence that the S corporation paid an unrelated non-owner a similar amount for providing similar services.  External data may come from a survey or database which has compiled actual compensation amounts paid by other companies, preferably in the same industry and the same geographic location.  The salary information must be reliable so don’t bank on whatever can be found free on-line.  The positions for which you provide comparability data must be sufficiently analogous to the shareholder's position within his or her company.  The shareholder's role in the business, however, may be more substantial than any one typical position. Owners often do “whatever needs to be done” and work with more passion than non-owners.  However, it may not be necessary for a shareholder to be paid within the range of comparability data.  But be well prepared to explain why he or she was paid amounts outside the range and have documentation to support that position.

Fifth, pull together documentation which helps to show which services the shareholders performed and which they did not perform.  This could include emails, contracts, employment agreements and other records.

Sixth, remember that compensation amounts determined by arm’s length negotiations among shareholders may be considered to be reasonable based on an agreement among parties with adversarial interests.  In Allen L. Davis, et al v. Commissioner of Internal Revenue, T.C. Memo 2011-286, the Tax Court considered an unusual set of facts.  Allen Davis and his two adult sons were shareholders of an extremely profitable S corporation but there was strife and litigation among the family members.  When Mr. Davis exercised a stock option that he had been granted less than two years earlier, the company deducted almost $37 million of compensation expense.  The Tax Court ruled that the amount was not unreasonable based primarily on the facts that Mr. Davis’ sons had agreed to the option grant and they had interests that were adversarial to those of their own father.

The Davis ruling is distinguished because the court did not rely on the usual factors, comparability data or the hypothetical investor test.  Instead, the court decided that Mr. Davis’ compensation amount must have been reasonable since the other shareholders had agreed to it when the option was granted.  The opinion states, “The granting of the Allen Option was reasonable because it was not a one-sided bargain.”  In effect, the court relied on the other shareholders to determine whether the compensation was reasonable.

In May 2013, the Eleventh Circuit affirmed the Tax Court’s decision in Davis, allowing the company to deduct the $37 million and requiring Allen Davis to report that amount of compensation income.


An S corporation faces stiff penalties if it fails to report compensation.  First, Section 6651(a)(1) imposes a penalty for failure to file Form 941 for each quarter unless such failure is due to reasonable cause and not due to willful neglect.  The penalty is 5% of the amount of the tax required to be shown on the delinquent return for each month or fraction thereof during which the return remains delinquent, up to a maximum of 25%.

Tip:  An S corporation should consider filing Form 941 each quarter, even though it may not have paid any wages.  Then, in the event of a re-determination, the company can at least avoid the penalty for failing to file payroll returns.

Second, the IRS may determine that the company is liable for a penalty under Section 6656 for failure to deposit the amount of tax that should have been withheld from the employee’s paychecks (the employee’s share).  This penalty is equal to 10% of the underpayment.  To avoid this penalty, the company must show that such failure was due to reasonable cause and not willful neglect.

Third, the Section 6672 penalty for failing to pay the employer’s share of payroll taxes is 100% of the taxes owed.

Finally, an additional penalty may be imposed for failure to issue a Form W-2.  To avoid these penalties, be sure you are well prepared to defend your positions.

Please Note

This article provides a brief overview of a complex subject.  This information is provided only to encourage meaningful discussion and is not intended to be advice for any specific party.  The tax laws change often.  Please seek professional counsel before making any final decisions. Atlantic Executive Consulting, LLC does not provide legal advice or sell any financial products.

Stephen Kirkland serves as an expert witness in U.S. Tax Court and other courts on issues involving potentially unreasonable compensation.  He can be reached at (803) 724-1414 or by EMAIL.


The Internal Revenue Service’s Internal Revenue Manual provides the following guidance to revenue agents when they are examining officer compensation on S corporation returns:
Part 4. Examining Process
Chapter 35. Partnership and S Corporations
Section 2. Audit Techniques for Business Returns (05-05-2006)

Officer's Salaries

1. Determine total compensation paid or accrued to principal officers, taking into consideration any compensation claimed under headings other than officers' salaries, such as manufacturing salaries, supervisory salaries, labor, etc., contributions to pension plans for the officers, payments of personal expenses, year-end or other bonuses, etc.
2. Determine if and to what extent each principal officer's compensation is unreasonable.
3. The examiner should take into account such factors as: nature of duties, background and experience, knowledge of the business, size of the business, individual's contribution to profit making, time devoted, economic conditions in general, and locally, character and amount of responsibility, time of year compensation is determined, whether alleged compensation compensate is in reality, in whole or in part, payment for a business or assets acquired, the amount paid by similar size businesses in the same area to equally qualified employees for similar services, etc.
4. Be alert to closely held multiple corporation situations in which compensation may be split between two or more related corporations, and which, in the aggregate, may be considered excessive to the officer-stockholder.
5. In closely held corporations, determine that accruals payable to controlling stockholders are paid within the prescribed time limit. Under IRC section 267(e), no deduction is allowed for accrued compensation to an S corporation shareholder.
6. Determine if executives have received substantial bonuses under the guise that the proceeds would be used by the recipient to make significant political contributions.
7. Be aware of excessive compensation to S corporation officer/shareholders for the purpose of avoiding the built-in gains tax of IRC section 1374., avoiding taxable dividend distributions or shifting income amongst shareholders.
8. Be aware of inadequate salaries paid to officer/shareholders who receive substantial nontaxable distributions. S corporation earnings are not subject to the self-employment tax, so officer/shareholders often receive minimal small or no wages salary income to avoided employment taxes.

Copied from www.irs.gov/irm/part4/irm_04-035-002.html


It's 9:30 AM. Do you know where your auditor is?


GAO Study of S Corporation Tax Compliance

The U.S. Government Accountability Office (“GAO”) conducted a study of tax compliance among S corporations. On December 15, 2009, the GAO published the results of its study, saying that there were “nearly 4 million” businesses operating as S corporations in 2006.  The published report also said that some S corporations “failed to pay adequate wages to shareholders for their labor for the corporation.”  It went on to say that “inadequate shareholder wage compensation is a significant issue.  Using IRS data, GAO calculated that in the 2003 and 2004 tax years, the net shareholder compensation underreporting equaled roughly $23.6 billion.” 

More information about this GAO study can be found at: http://www.gao.gov/products/GAO-10-195

The IRS has focused considerable attention to this compensation issue in recent years.  When they believe that unreasonably low compensation amounts have been paid, they can expand their inquiry into other areas.  To help avoid an IRS audit, shareholders should consider using comparability data to support the amounts that their S corporations treat as shareholder compensation. 

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