S-Corporation Reasonable Compensation Audits

The IRS has increased its audits of small businesses. A common issue is whether or not the owners or officers of an S-Corporation are paying themselves adequate, or for that matter, any salary. Often, S Corporation owners pay themselves little or no salary, and simply take their income through distributions reported on Form K-1 at the end of the year. This is done to avoid paying payroll taxes since none are due on corporate distributions but are clearly due on salaries paid to corporate shareholders.

The IRS looks at a number of issues. 1) Is the nature of the business such that revenue is driven more by the corporation's capital, assets, and other employees, than by the shareholder's personal efforts? 2) What are the qualifications and responsibilities, and how much time and effort is devoted to the business by the shareholder? 3) Is the shareholder being paid the same or less than non-shareholder employees? 4) What are comparable businesses paying for the same types of services? 5) Are the distributions substantially greater than the salary? 6) What is the financial condition of the business? These are all factual issues to be determined on a case by case basis, but paying oneself little or no salary, while taking large distributions, is an excellent way to attract an audit. Shareholders should address this issue with their tax consultants in an effort to arrive at a reasonable balance between compensation and distributions.