Don’t Get Ambushed: The IRS Is Arming and So Should You

By Paul S. Hamann & Jack Salewski, CPA, CGMA

For two decades the IRS has been preparing an assault on reasonable compensation for S Corporations. Their arsenal is now fully stocked. In it there’s everything from commonsense tools to obscure memos. Get ready. Arm yourself with facts and data, because fiction and myths aren’t going to protect you.

COVID gave S Corps a short cease fire. By 2019 examiners had been trained to address the long-standing concern over inadequate reasonable compensation and bring S Corp. owners into compliance.  Audits picked up. A look at this new initiative was to follow in 2020 with a TIGTA report, then COVID hit. Last year saw little activity and the TIGTA report was never produced.

So, will the IRS resume its assault on S Corps and owners’ compensation in 2021? We consulted our magic eight ball for the answer, but it was little help [Ask Again Later]. Our best advice is to get ready, because even if the IRS doesn’t show up in 2021, they are still likely to show up soon, locked and loaded.

To understand how we got to this point, let’s jump in our Wayback Machine:

  • 2000: The IRS establishes its authority to reclassify distributions as wages in Joly v. Commissioner.
  • 2001: The IRS reinforces the employment status of shareholders as employees in Veterinary Surgical Consultants, P.C. v. Commissioner and Joseph M. Grey Public Accountant, P.C. v. Commissioner.
  • 2002: The alarm is sounded in a TIGTA report that points out average wages were $5,300 and average distributions were just under $350,000.
  • 2005: The IRS launches a compliance study of S Corps and reasonable compensation.
  • 2008: The IRS releases basic guidelines and criteria for determining reasonable compensation in Fact Sheet 2008–25
  • 2009: The GAO releases a report summarizing the 2005 compliance study confirming reasonable compensation under reporting was a major compliance problem, stating “the net shareholder compensation under reporting equaled roughly $23.6 billion (2002-2003).”
  • 2010: The IRS tests its new compliance and enforcement strategy in the courts winning the landmark case David E. Watson, P.C., v. United States of America (and Appeal in 2012). The Watson case established the IRS’s right to require “reasonable reimbursement for services performed.” In layman’s terms: set reasonable compensation based on the services performed by the shareholder.
  • 2011: The IRS begins requiring form 1125-E for companies with more than $500,000 in revenue, requiring owner’s compensation be disclosed and begins to build an internal data set on owners’ compensation.
  • 2012: A TIGTA report shows that in just a three-year period, the average adjustment for each return audited went from just over $50,000 (GAO report for 2002-2003) to just over $105,000 (2007-2011). The IRS gains momentum.
  • 2013: The IRS wins two more landmark cases: McAlary V. Commissioner and Glass Blocks Unlimited V. Commissioner. McAlary provides insight on how to calculate reasonable compensation. Glass Blocks establishes that reasonable compensation can be required even when a company is losing money.
  • 2014: The IRS produces an internal job aid on reasonable compensation. The job aid includes three recognized approaches for determining reasonable compensation.
  • 2015: Examiners begin to assess preparer penalties on tax professionals when they adjust a client’s reasonable compensation.
  • 2017: An internal memo from the Office of Chief Counsel Internal Revenue Service lays out steps examiners and appeals agent should take to keep reasonable compensation challenges out of Tax Court.
  • 2018: The IRS trains 2,500 agents from the Austin, TX field office specifically on reasonable compensation. In addition, all examiners must now make sure compensation is considered in examinations of closely held S Corps.
  • 2019: Michael Gregory (who developed the internal job aid for the IRS) confirms a Forbes story anticipating a rise in S Corp audits. RCReports notices a rise in usage for historical years; this typically suggests more reasonable compensation challenges.
  • 2020: The TIGTA report that wasn’t. Scheduled for release in 2020, this report was to be an updated look at progress the IRS has made on reasonable compensation compliance. Due to COVID, this report was not produced (yet).

The best way to prepare for a reasonable compensation challenge is to be proactive. This means determining reasonable compensation using the IRS’s own criteria and guidelines, not the fiction and myths of the past.



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