Helping S corporations avoid unreasonable compensation audits

Find out what entries on Forms 1120S may trigger these audits.
By Stephen D. Kirkland, CPA/CFF

 Helping S corporations avoid unreasonable compensation audits
Illustrations by nidwlw/iStock

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.

Multifactor 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 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 Group LLC.

AICPA resources

JofA articles


  • The 2015 Cumulative Tax Guide (#PTX1405D, online access)
  • The Adviser's Guide to S Corporations: Tax Compliance and Planning Strategies (#PTX1502P, text; #PTX1502E, ebook)
  • The IRA Distribution Rules: IRS Compliance and Audit Issues (#PPF1402P, paperback; #PPF1402E, ebook)
  • Slashing Taxes for Your Small Business Clients: Corporations, Partnerships, & LLCs (#736210, text; #163680, one-year online access)

CPE self-study

  • 2014 Corporate Income Tax Workshop and Videocourse (#735219, text; #153435, one-year online access; #112645, DVD/manual)
  • S Corporations: Key Issues, Compliance, and Tax Strategies (#736161, text; #163420, one-year online access)
  • Tax Staff Essentials, Levels 1—4 (#157630, #157720, #157790, and #157860, one-year online access for each level)

For more information or to make a purchase, go to or call the Institute at 888-777-7077.

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