The IRS Hunt for S Corporation Compensation Underreporting

There are a lot of issues for management to keep top of mind these days. The pandemic, of course. The political landscape, and its ever-present promise (or threat, depending on your viewpoint) of new legislation.

Then there’s inflation, supply chain problems, worker shortages… the list is endless, right? Is there even time for other business concerns? Certainly there is! And tools like the Schneider Downs Our Thoughts On series can help you keep track of them. Today, let’s discuss whether officer compensation in S corporations should be added to that already long list of things to consider sooner rather than later.

S corporations are required to report reasonable compensation for the services that shareholder-employees perform for the company.  That compensation is subject to employment taxes.  An issue arises if shareholder-employees receive distributions, dividends or other forms of compensation instead of wages in an effort to avoid paying employment taxes.

It may appear that the IRS has not been thinking too much about officer compensation, given that less than one percent of all S corporations are chosen for examination. Of those selected, almost half of the examinations don’t look at officer compensation, based on a report issued by the Treasury Inspector General for Tax Administration (TIGTA) dated August 11.

The report, entitled Efforts to Address the Compliance Risk of Underreporting of S Corporation Officers’ Compensation are Increasing, but More Action Can Be Taken, is the first TIGTA report on shareholder compensation since 2012. Its purpose is to determine whether the IRS’ current compliance efforts surrounding officer compensation are sufficient. As the title suggests, TIGTA advises the IRS to expand its compliance efforts. The agency estimates that between processing years 2016 and 2018, approximately $25 billion in compensation may not have been reported, resulting in unpaid FICA tax of roughly $3.3 billion.

TIGTA makes several recommendations within its report, one of which is that the Commissioner of the Small Business/Self-Employed Division of the IRS should evaluate the risks of noncompliance with officer compensation and consider updating the examination plan. TIGTA also recommends the IRS evaluate the benefits of using a threshold and specific criteria as part of classification guidance and use compliance results from established workstreams to inform decision-making.

Although IRS management took issue with some of the conclusions drawn and recommendations proffered, one thing is certain—while TIGTA and IRS management may not completely agree on the most efficacious policies and procedures going forward, IRS scrutiny of shareholder compensation is here to stay. Case in point, in August 2020, the Small Business/Self-Employed Division of the IRS launched a compliance initiative project to focus more resources on this topic, which will likely result in officer compensation challenges outside the traditional audit process.

If you have any questions or concerns regarding reasonable compensation in S corporations, we’re here to help! Schneider Downs has significant experience preparing compensation analyses. Please contact Jen Doering (412-697-5275; [email protected]) for more information about our compensation consulting services.