IRS Scrutiny of Unreasonable Salaries Likely to Continue

If your company is structured as an S corporation, you more than likely considered the tax advantages of this entity choice. But, as is the way of the world, tax advantages also give rise to IRS scrutiny. And the agency has made clear that its interest in S corporations will continue.

Why the audits?

The IRS pays particular attention to S corporations because shareholder-employees of these organizations (unlike, say, general partners in partnerships) aren’t subject to self-employment taxes on their respective shares of the company’s income. In light of this, many S corporations seek to manage their payroll tax liability by minimizing shareholder-employee salaries and compensating them mostly via “dividend” distributions.

Sound familiar? If so, the IRS probably will at some point take a close look at your shareholder-employee salaries (if it hasn’t done so already) to see whether they’re unreasonably low. The agency views unreasonably minimized salaries as an improper means of avoiding payroll taxes.

If its case is strong enough, the IRS will recharacterize a portion of distributions paid to the shareholder-employee in question as wages and bill the employer and/or employee for unpaid taxes, interest and possibly even penalties.

Are more audits coming?

Late last year, the IRS announced eight emerging or significant areas that it will prioritize for 2013. (The announcement applied specifically to small businesses, but midsize and larger ones certainly won’t be ignored.)

Sure enough, S corporations made the list. Yet what’s frustrating many business owners is that this announcement comes on the heels (relatively speaking) of a 2012 report by the Treasury Inspector General for Tax Administration showing that most S corporation audits produce little, if any, results: Sixty-two percent of the S corporation tax returns selected for auditing were eventually closed by the IRS with no recommended changes.

The bright side, of course, is that this means you have a good chance of coming out of an audit without facing additional taxes, interest and penalties — provided you can support the reasonableness of your shareholder-employee salaries.

What defines “reasonable”?

By following certain guidelines, you can help ensure salaries paid to shareholder-employees have a high likelihood of meeting the agency’s typical standards of reasonableness.

For starters, do some benchmarking to learn how S corporations of similar size in your industry and geographic region are paying their shareholder-employees. Your company’s comparable size, as indicated by its capital value, net income or sales, will also be a factor.

In addition, pay close attention to certain traits held by your shareholder-employees. These include:

  • Background and experience,
  • Specific responsibilities,
  • Work hours,
  • Professional reputation, and
  • Customer relationships.

The stronger these traits are, the higher the salary should be in the eyes of the IRS. Shareholder-employee salaries should be fairly consistent from year to year, too, without dramatic raises or cuts.

Is there a recent example?

The 2012 case of Watson v. U.S., heard by the U.S. Court of Appeals for the Eighth Circuit, provides some key insights into what the IRS looks for in an audit. The details of the decision are complex but, in short, the defendant was an experienced, full-time CPA who reported a mere $24,000 salary while taking more than $200,000 in distributions.

The IRS assessed substantial taxes, penalties and interest, which the defendant paid. But, soon after, he sought a refund for them. When the agency refused the refund, the case went to a district court that affirmed the IRS’s findings.

On appeal, the Eighth Circuit also denied the refund claim. It pointed to, among several things, the defendant’s educational background and experience as a CPA as well as the fact that he was one of the primary earners for a firm with earnings that exceeded those of many comparable accounting firms.

Who can help?

As your S corporation battles with its competitors and the economy as a whole, you may not give shareholder-employee compensation much attention. The best approach is to, under the guidance of your tax advisor, examine the reasonableness of these salaries now — before the IRS comes calling.