Dear Client,
There is a potential audit risk that S-Corporations face regarding the compensation of their owners. As you may know, S-Corporations are pass-through entities that do not pay corporate income tax, but rather pass their profits and losses to their shareholders, who report them on their individual tax returns. One of the benefits of being an S-Corporation owner is that you can avoid paying self-employment taxes (Social Security and Medicare taxes) on the portion of your income that is distributed as dividends, rather than wages. However, this also creates an incentive for some owners to underreport their wages and overreport their dividends, which can attract the attention of the IRS.
The IRS requires that S-Corporation owners who perform services for their businesses pay themselves a reasonable salary for their work, and report it as W-2 income subject to employment taxes. The IRS can reclassify dividends as wages if it determines that the owner’s compensation is unreasonably low compared to the profits of the business. This can result in additional taxes, penalties, and interest for the owner and the S-Corporation. The IRS has various methods to identify and select S-Corporations for audit, such as matching K-1s with W-2s, using thresholds and criteria based on income and losses, and analyzing various deductions and credits claimed by the business.
According to a recent report by the Treasury Inspector General for Tax Administration (TIGTA), the IRS is not doing enough to enforce compliance with the reasonable compensation requirement for S-Corporation owners. TIGTA found that many S-Corporations with high profits and low or no wages were not selected for audit, and that even when they were audited, the issue of owner compensation was often not evaluated by the IRS agents. TIGTA recommended that the IRS improve its audit selection and examination procedures to address this issue more effectively.
As your legal advisors, we want to help you avoid any potential audit risk and ensure that you comply with the tax laws regarding your S-Corporation. We can assist you in determining a reasonable salary for yourself based on various factors, such as your duties and responsibilities, your qualifications and experience, the nature and size of your business, the market conditions and industry standards, and the compensation paid by comparable businesses. We can also help you document your compensation decision and support it with evidence in case of an IRS inquiry.
We hope this letter has been informative and helpful to you. If you have any questions or concerns about this issue, please do not hesitate to contact us.