If you work with S corporations, you’ve probably seen the CP261 notice—the IRS letter confirming an S election. For years, it was a simple acknowledgment. That changed in late 2023. The IRS added language about reasonable compensation, and it’s not just a suggestion. It’s a compliance warning.
What Changed?
The revised notice now includes language stating:
“You must determine a reasonable salary when a shareholder-employee of an S corporation provides services to the corporation. Payments to a shareholder-employee for services provided to an S corporation are wages and are subject to employment taxes. We may re-characterize distributions paid to a shareholder as salary if the distribution was paid in lieu of reasonable compensation.” (Revenue Ruling 74-44)
This addition signals a renewed IRS focus on compliance for S corporations. Historically, CP261 simply confirmed your election. Now, it doubles as an enforcement tool.
Why the Change?
The IRS is tightening enforcement on S corps. Underpaying wages and taking large distributions has been a common tax strategy. This update signals that those days are numbered. The agency wants payroll taxes collected and is using CP261 to set expectations early.
How is Reasonable Compensation Determined?
It’s not a formula like ‘60/40.’ It’s based on what similar businesses would pay for similar work and IRS recognized methodologies. Factors include: Duties and hours, Industry norms, Location, Court precedents, Experience and qualifications. Document how you arrive at the number. If you can’t defend it, you’re exposed.
What Happens if you Ignore it?
Expect reclassification of distributions, back payroll taxes, penalties, and interest. And with the IRS creating a dedicated passthrough entity group, audits in this area will increase.
How Accountants Can Help
Start the conversation now. Review client compensation practices before year-end if possible. Use RCReports to support your numbers. The cost of doing nothing is far higher than the cost of getting it right.
Why does the IRS website still show dates from 2017 on the sample CP261 when it was updated in 2023?
Because the IRS updated the language but not the dates on the sample notice. This has caused a lot of confusion as to when the notice was updated. We investigated, and the notice was updated in late 2023. Why didn’t the IRS update the entire notice? Because apparently, updatingthe actual letter was enough heavy lifting for one year. Consider it their version of a shortcut… or a time capsule for tax nerds.
