“More Action Can Be Taken”: IRS Aims Big Data at Officer Compensation

IRS looking at officer compensation under reporting

Just how big of an issue is S Corp. officer compensation under-reporting? Big would be an understatement. The most recent estimate (TY 2011-2013) has S Corp. owners underreporting compensation by $24 billion per year, twice as much as ten years earlier.

So, what is the IRS doing about it?

Last month Treasury Inspector General for Tax Administration (TIGTA) released its first report on S Corp.’s and officer compensation since 2012. The report is a mixed bag of positives and negatives for the IRS’s compliance efforts on the subject. The formal title, “Efforts to Address the Compliance Risk of Underreporting of S Corporation Officers’ Compensation Are Increasing, but More Action Can Be Taken” is a good CliffsNotes summary of the report (bonus points if you remember CliffsNotes). Note the warning at the end.

The overall objective of this report was to determine whether or not the IRS’s policies procedures and practices are adequately ensuring that compensation is considered in examinations of closely held S Corp. and its shareholders.

For S Corp.’s and their shareholders not paying adequate reasonable compensation, the chances of getting caught through an audit are just 1%.  However, It’s the IRS’s new data-driven compliance programs that under-reporters and their tax advisors need to worry about. The IRS is currently running two specialty compliance programs that target Officer Compensation:

    1. Within the Specialty Examination Employment Tax Program that has been in place since about 2015, the IRS has a Specialty Workstream focused solely on S Corp. officers’ compensation. Examiners are instructed to assess Preparer Penalties when an adjustment to an officer’s reasonable compensation is made. This program reviewed 12,362 returns between 2016 and 2018, returning an average adjustment of $17,726.
    2. In August 2020 the SB/SE Division of the IRS began a National Compliance Initiative to target officers’ compensation and distributions, throwing even more resources into the issue. It stands to reason we should see an increase in officer compensation challenges outside the traditional audit process.

So, what does “outside the traditional audit process” mean? In this case, it means Compliance Initiative Projects or CIPs. CIPs are designed to (among other things):

  • Identify trends of non-compliance and improper treatment of tax issues
  • Use data-driven decisions as to the basis for expending resources

Technology and big data are being deployed to combat compensation under-reporting. The IRS’s Office of Research, Applied Analytics, and Statistics provided details of a 2018 pilot program that tested a systematic classification process called “Issue Recommender.” Issue Recommender uses algorithms to identify anomalies and commonalities among similarly situated tax returns. The Issue Recommender has not yet been tested on Forms 1120-S, but if tested and found to be successful it would potentially replace the current manual classification process with an automated one.

So, will the IRS’s Officer Compensation CIP succeed? Well, if a CIP focused on the Cannabis Industry is any indication, the answer is not just yes – but Hell Yes. In addition, a look at RCReports internal reporting indicates an increase in reasonable compensation challenges for the first time since 2015, confirming the title of the TIGTA report “Efforts to Address the Compliance Risk of Underreporting of S Corporation Officers’ Compensation Are Increasing, but More Action Can Be Taken.”.

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