Category: IRS Audits

If you’re a shareholder in an S Corporation, ensuring that your compensation is reasonable is crucial to avoid IRS scrutiny. But how do you calculate and document reasonable compensation? Follow this straightforward process to establish a well-supported, defensible compensation figure using publicly available data and clear documentation.

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Step 1: Download State Wage Data

The Department of Labor (DOL) releases annual wage data by state each May. This dataset provides a comprehensive breakdown of average wages for different occupations and industries in your area. Start by downloading this data and importing it into a spreadsheet. This will serve as your baseline for determining reasonable pay rates.

Pro Tip: Focus on your specific state to ensure your compensation aligns with local economic conditions. Bookmark the DOL website or set a reminder each May to update your data.

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Step 2: Identify Major Duties

Make a detailed list of your primary job responsibilities as a shareholder-employee. Most shareholders in S Corporations wear multiple hats, so aim to capture 4 or 5 major functions you perform regularly. For example:

• Sales and Business Development
• Operations Management
• Financial Oversight
• Customer Support
• Administrative Tasks

Defining your roles ensures you match each duty to an appropriate wage category.

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Step 3: Look Up Average Pay Rates

Using your spreadsheet of DOL wage data, find the average hourly rate for each of your identified duties. For instance:

• Sales and Business Development: $45/hour
• Operations Management: $50/hour
• Financial Oversight: $55/hour
• Customer Support: $25/hour
• Administrative Tasks: $20/hour

Make sure the rates reflect your state and industry. If necessary, adjust based on the experience required for the role.

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Step 4: Allocate Your Time by Duty

Next, estimate your time on each duty during a typical workweek. Break this down as a percentage, ensuring the total does not exceed 40 hours per week. For example:

• Sales and Business Development: 40% (16 hours/week)
• Operations Management: 25% (10 hours/week)
• Financial Oversight: 15% (6 hours/week)
• Customer Support: 10% (4 hours/week)
• Administrative Tasks: 10% (4 hours/week)

Allocating your time helps demonstrate how your compensation correlates with the value of your work.

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Step 5: Calculate Total Compensation

Now, multiply the hours spent on each duty by the corresponding hourly rate, then sum the totals:

• Sales and Business Development: 16 hours × $45/hour = $720
• Operations Management: 10 hours × $50/hour = $500
• Financial Oversight: 6 hours × $55/hour = $330
• Customer Support: 4 hours × $25/hour = $100
• Administrative Tasks: 4 hours × $20/hour = $80

Total Weekly Compensation: $1,730
Annualized Salary (52 weeks): $1,730 × 52 = $89,960

This total represents a well-documented, reasonable compensation figure that reflects your duties and local wage standards.

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Why This Approach Works

By following these steps, you’re creating a clear paper trail that aligns with IRS guidelines. Using third-party wage data, documenting job duties, and allocating time builds a solid defense if your compensation is questioned. It’s proactive and transparent and ensures you remain in compliance.

IRS Agents are used to seeing taxpayers with no documentation. Yours does not have to be pretty to be adequate.

Bonus Tip: Keep this documentation updated annually and include it with your corporate records to show consistency.

For S Corporation owners, balancing compensation can be a tightrope walk. Unlike other business structures, S Corporations offer a unique tax advantage: distributions to shareholders are not subject to payroll taxes. But here’s the catch—if you’re actively working in your S Corporation, the IRS requires you to pay yourself a reasonable salary before taking those tax-free distributions. Mess this up, and you could be inviting an audit. Let’s dive into the most common red flags for S Corporations regarding compensation.

The IRS’s Biggest Target: Paying Zero Salary

If you’re a shareholder-employee of an S Corporation and pay yourself no salary, you’re putting a giant bullseye on your back. The IRS has made it clear that zero salary is not acceptable for any owner who actively works in their business. Why? Because wages are subject to payroll taxes (Social Security and Medicare), while distributions are not. By avoiding salary, you’re dodging these taxes, which will almost certainly trigger an IRS audit.

Other Common Triggers That Could Lead to an Audit

Beyond paying zero salary, here are other red flags the IRS watches for in S Corporations:

1. Unreasonably Low Salaries

Another major red flag is paying yourself a salary but setting it way below what someone in your role would typically earn. For instance, if you’re running a thriving business but only paying yourself $15,000 a year while taking $200,000 in distributions, the IRS might see this as an attempt to avoid payroll taxes. They’ll likely reclassify part of your distributions as wages, slapping you with back payroll taxes, penalties, and interest.

2. Disproportionate Salary to Distributions Ratio

The IRS often looks at the ratio of your salary to distributions. If you’re taking minimal salary and large distributions, it could signal an attempt to skirt payroll taxes. While there’s no hard-and-fast rule, a significant imbalance will catch the IRS’s attention.

3. Industry-Out-of-Whack Compensation

The IRS compares your salary to industry standards for similar roles. If your salary falls well below what others in your industry typically earn for the same job, it raises a red flag. For example, the IRS will likely question your compensation if you’re a tech consultant but only paying yourself $30,000 a year while the industry average is $100,000.

How the IRS Determines Reasonable Salary

The IRS uses several factors to determine what constitutes a reasonable salary for S Corporation owners, including:

• Your role and responsibilities. Are you the CEO? A manager? Or someone performing administrative tasks?
• Time spent working. The more hours you work, the higher your salary should be.
• Industry standards. Salaries for comparable positions in similar businesses are a key benchmark.
• Company size and profitability. A highly profitable business typically warrants a higher salary for its owner.

The Cost of Non-Compliance

If the IRS decides your salary is unreasonable, they can reclassify your distributions as wages. This means:

• You’ll owe back payroll taxes (Social Security and Medicare) on those reclassified amounts.
• You could face penalties for underpayment of employment taxes.
• The IRS may tack on interest for the time those taxes went unpaid.

How to Stay Compliant

To avoid trouble, follow these best practices:

• Set a reasonable salary. Use industry benchmarks, your role, and your business’s profitability as a guide.
• Document everything. Keep records of your duties, hours worked, and how your salary was determined.
• Consult a tax professional. A CPA or tax advisor can help you structure your compensation correctly while minimizing your tax burden.

Final Thoughts

For S Corporations, paying a reasonable salary is more than just good practice—it’s a requirement. The IRS focuses on shareholder-employee compensation, and paying zero or unreasonably low salaries is the quickest way to get audited. By ensuring your salary aligns with your role and industry norms, you can enjoy the benefits of S Corporation tax savings without the risk of penalties. Play by the rules and keep your business and the IRS happy.

There’s good news if you’ve ever been stressed about not having every receipt for your tax deductions. Almost 100 years ago, a principle was established that still benefits taxpayers today—it’s called the “Cohen Rule.” Born out of the 1930 Cohen v. Commissioner case, this rule remains a powerful tool, saving taxpayers from being unfairly penalized when documentation is missing or incomplete. And believe me, it’s still relevant—even though some may have thought it had faded into obscurity.

My Experience as an IRS Agent: Is the Cohen Rule Dead?

When I was an IRS Agent decades ago, my Group Manager often claimed the Cohen Rule was dead. I heard it all the time. But even then, I knew better. In practice, the Cohen Rule was still quietly applied in cases where taxpayers couldn’t produce every receipt but had reasonable, credible deductible estimates. And today, it’s still doing exactly that—protecting taxpayers who may not have a perfect paper trail.

The Origins of the Cohen Rule

The rule originated when George M. Cohen, a famous Broadway producer and performer, faced a challenge we all can relate to: he claimed deductions for business expenses. Still, he didn’t have every receipt on hand. The IRS disallowed those deductions, but Cohen argued that the expenses were reasonable and ordinary for his line of work. The court ruled that if a taxpayer could provide reasonable estimates for legitimate expenses, the deductions could still be allowed, even without perfect documentation.

How the Cohen Rule Helps Taxpayers Today

Fast forward nearly 100 years, and the Cohen Rule remains vital, especially for non-filers trying to get back on track. When you’ve fallen behind on filing taxes, tracking down every bit of paperwork can feel impossible. The IRS typically requires documentation for expenses, but if you don’t have all your records, the Cohen Rule can help. It allows taxpayers to estimate certain expenses as long as they’re reasonable and supported by other evidence, like bank statements or testimony.

Impact on Non-Filers

This flexibility is crucial for non-filers. Imagine trying to catch up on several years of taxes but missing essential receipts for legitimate expenses. Without the Cohen Rule, you could face hefty penalties, interest, and additional taxes just for not having every document. But the rule provides some much-needed breathing room, recognizing that life isn’t always perfect, and neither is paperwork.

Conclusion: The Cohen Rule Still Offers Relief

In a world where tax compliance can feel overwhelming, the Cohen Rule is still quietly offering taxpayers a fair chance—even decades after my manager claimed it was dead. For those behind on their taxes or who don’t have every receipt in hand, it’s a reminder that reasonable, honest efforts to comply are still respected.

When a taxpayer fails to file a return or keeps inadequate records, the IRS doesn’t just shrug and give up on assessing tax. Instead, it has a range of tools at its disposal to estimate a person’s taxable income through what’s known as “indirect methods.” These techniques help the IRS reconstruct income when accurate records are unavailable, ensuring that non-filers are held accountable.

What Are Indirect Methods?

Indirect methods refer to various approaches the IRS can use to estimate an individual’s or business’s income when direct evidence, like bank statements or tax returns, is incomplete or missing. These methods rely on external sources of information and lifestyle indicators to paint a picture of the taxpayer’s financial situation.

Some of the most commonly used indirect methods include:

1. Bank Deposits Method: This involves analyzing taxpayers’ bank accounts to identify deposits. The IRS assumes that most bank deposits reflect income unless proven otherwise, such as loan repayments or gifts. The IRS adjusts for known non-taxable deposits, but unexplained amounts are generally considered taxable.
2. Net Worth Method: The IRS assesses changes in a taxpayer’s net worth over time by examining assets, liabilities, and expenditures. If a taxpayer’s wealth significantly increases without a corresponding explanation (like inheritance or gifts), the IRS may attribute that growth to unreported income.
3. Expenditures Method: This method assumes that a person’s income must cover expenses. The IRS can estimate income levels by evaluating a taxpayer’s spending patterns. For example, if someone is living a high-cost lifestyle but there’s no evidence of reported income, the IRS may assume that unreported income is financing those expenses.
4. Markup Method: Typically used for businesses, this method calculates income based on the cost of goods sold and expected profit margins. Suppose a business doesn’t have records or reports less income than seems plausible. In that case, the IRS uses industry standards to estimate the revenue based on purchases and standard markup rates.
5. Cash-T Analysis: This approach looks at taxpayers’ cash on hand and spending. If someone spends more money than they could reasonably withdraw or earn based on their reported income, the IRS may infer additional unreported cash income.

Are Indirect Methods Likely to Overstate Income?

Indirect methods rely heavily on assumptions, which means the IRS could overestimate taxable income. For instance, if the IRS mistakenly classifies a non-taxable deposit as income or overlooks legitimate expenses, the taxpayer’s income could be overstated. However, taxpayers can challenge these estimates by providing evidence to the contrary. Proper documentation is crucial to avoid this scenario.

The Takeaway

Indirect methods are essential tools in the IRS’s arsenal, allowing them to estimate taxable income even when non-filers try to evade detection. Anyone in this situation should understand that the IRS can and will find ways to calculate your income. If you’re concerned about unfiled returns or incomplete records, it’s always better to voluntarily file and communicate with the IRS before they contact you with these indirect techniques.

One of S corporation owners’ most crucial tax considerations is determining “reasonable compensation.” The IRS scrutinizes S corporation shareholders’ compensation because it impacts how income is taxed. While S corporation shareholders can take salary and distributions, only the salary is subject to payroll taxes. Distributions are not, making it tempting to underpay salaries. However, doing so can lead to IRS penalties if the salary is deemed unreasonably low.

What is Reasonable Compensation?

Reasonable compensation is the salary an S corporation owner must pay themselves for the services they provide to the business. The IRS expects this salary to reflect what someone in a similar role with similar experience would earn in the market.

The IRS looks at factors such as:

• The shareholder’s duties and skills
• Time and effort spent on the business
• Comparable salaries in the industry
• The company’s gross revenue and profits

How to Calculate Reasonable Compensation

1. Research Comparable Salaries
Use resources like the Bureau of Labor Statistics (BLS) or salary surveys to find salary data in your industry and region. For example, if the owner is both a CEO and performs technical work, combine salaries for those roles.

2. Consider Hours Worked
Estimate the time spent on each role and calculate compensation based on that split.

3. Factor in Company Financials
Your compensation should also reflect the financial health of your business. Higher profits may justify a higher salary while struggling businesses might opt for more modest compensation.

The Importance of Documentation

Maintaining documentation or a study to support your salary calculation is crucial. Without this, you leave the determination of what is “reasonable” to an IRS auditor if you’re ever examined. This could result in the auditor setting a higher salary than you paid yourself, leading to back payroll taxes, penalties, and interest.

If the IRS determines underreported wages, they will likely apply the adjustment to all three open tax years, increasing your liabilities.

Conclusion

Determining reasonable compensation for S corporation owners is critical to avoiding payroll taxes and penalties. To protect yourself in the event of an audit, be sure to document your approach based on industry standards, duties, and financial performance.

For S corporation owners, reasonable compensation is crucial for staying compliant with the IRS. As both shareholders and employees, owners must pay themselves a fair salary based on their work. This is important because shareholder-employees receive funds through wages (subject to payroll taxes) and distributions (not subject to payroll taxes). If the IRS believes an owner is underpaying themselves in wages while taking excessive distributions, it can lead to audits, penalties, and back taxes.

But what exactly is considered reasonable compensation, and why does it matter?

How the IRS Defines Reasonable Compensation

The IRS defines reasonable compensation as pay reflecting the value of services provided by the shareholder-employee. The salary should match what the company would pay someone else for the same duties. When determining reasonable compensation, the IRS considers several factors:

1. The Role and Duties Performed: Different jobs require different levels of compensation. For example, someone handling administrative tasks, like scheduling, would earn less than someone responsible for strategic planning or overseeing finances. The more complex and critical the role, the higher the pay should be. If an owner shapes the company’s vision or manages large teams, their salary should reflect that.
2. Industry Standards: The IRS compares the owner’s pay to what others in the same role, industry, and region earn. Owners can use salary surveys to ensure their pay aligns with typical compensation for similar duties.
3. Business Size and Financial Health: The IRS examines company revenue, profits, and size. Larger, profitable businesses are expected to pay higher salaries. A highly profitable S corporation that pays a modest salary but takes large distributions may raise red flags for the IRS.
4. Time and Effort: An owner’s time in the business also matters. An owner working full-time in a key role should receive a higher salary than someone working part-time or doing less critical tasks.

Why Reasonable Compensation Matters

Avoiding IRS Scrutiny: The IRS monitors S corp owners who pay themselves low salaries while taking large distributions, which avoids payroll taxes. If they suspect underpayment of wages, it can lead to an audit.

Tax Compliance: Payroll taxes fund Social Security and Medicare. If the IRS reclassifies distributions as wages, the business will owe back payroll taxes, interest, and penalties.

Ability to Borrow: Reporting a fair salary helps when applying for loans or working with investors, showing that the company complies with IRS rules.

Conclusion

Understanding reasonable compensation is vital for S-corp owners to avoid IRS scrutiny. Pay should reflect the role’s complexity, align with industry standards, and consider the company’s financial condition. By balancing wages and distributions, owners can protect their businesses from penalties and keep operations compliant.

While the thought of an IRS audit can be stressful, the reality is that only about 0.4% of individual tax returns are audited each year. However, certain red flags can increase your chances. Understanding these triggers can help you avoid mistakes and reduce your audit risk. Here are the most common situations that could lead to an IRS audit:

1. High Income Levels

The IRS is more likely to audit higher-income taxpayers. According to IRM 4.1.5.4, the IRS prioritizes cases where significant tax revenue is at stake. While the overall audit rate is low, those with incomes over $500,000 have a 1.1% chance of being audited. This jumps to 2.6% for individuals earning $1 million or more.

2. Unreported Income

Failing to report all income is a quick way to get the IRS’s attention. The IRS matches your tax return with the W-2s and 1099s they receive from employers and other sources. Any discrepancy, like income from freelancing or side jobs, could result in a CP2000 Notice, signaling a potential audit.

3. Large or Unusual Deductions

Claiming deductions that seem large relative to your income can raise red flags. For example, reporting $80,000 in income but claiming $40,000 in charitable donations may lead to scrutiny. Similarly, large deductions for business expenses or home office use could be questioned. The IRS uses DIF scores to identify unusual return patterns (IRM 4.10.5.2).

4. Claiming the Earned Income Tax Credit (EITC)

The Earned Income Tax Credit (EITC) is a valuable tax break for low-income families but is also heavily audited due to frequent errors. 1.2% of returns claiming the EITC are audited, which is higher than the general audit rate. If you claim the EITC, ensure that all information is accurate and supported by documents like proof of income and household size.

5. Self-Employment Income

Self-employed individuals are likelier to be audited because the IRS knows there’s more opportunity to underreport income or inflate deductions. High deductions for business expenses or home office use are common triggers. Keep detailed and accurate records to avoid issues.

6. Foreign Accounts and Assets

U.S. taxpayers must report foreign accounts if their value exceeds $10,000 at any point during the year. Failing to do so can trigger an audit and severe penalties. The IRS partners with foreign governments to find unreported foreign income, so compliance is key.

7. Round Numbers on Your Return

Filling out your return with rounded numbers, like exactly $5,000 for business expenses or $10,000 for donations, can look suspicious. While rounding to the nearest dollar is fine, avoid numbers that seem “too perfect.”

While the overall audit rate is low, knowing what behaviors increase your risk can help you avoid being flagged. By keeping accurate records and filing a precise, honest return, you can reduce the likelihood of facing an audit.