Tax authorities seem to have taken the first steps toward closing a reporting loophole for S corporations.

According to a government report, the Internal Revenue Service is selecting a tiny number of S corporations for examination to make sure they are complying with the payment of employment taxes. When the IRS does examine an S corp, many revenue agents don’t look closely enough at executive compensation, according to the agency that produced the report, the Treasury Inspector General for Tax Administration, which provides independent oversight of IRS activities.

In fact, the agency, also known as TIGTA, asserts that of the 14.8 million income tax returns filed by S corporations for calendar 2016 through 2018, only 32,000 were audited by the IRS—less than one quarter of 1% for each year, said James G. McGrory, a CPA and shareholder at Drucker & Scaccetti in Philadelphia.

Of those selected, officer compensation was selected as an issue during classification 14% of the time, added Miri Forster, partner and co-leader of the tax controversy practice for Eisner Advisory Group in New York. “With a population of 30% of S corporation returns having a single shareholder and no officers’ compensation reported, the report claims that the IRS exam rate of officers’ compensation does not match up with the potential risk,” Forster said.

She added that the IRS compliance campaign was focused on whether certain S corporation distributions have been properly taxed. The agency is looking at three types of distributions, she said: those of appreciated property where the S corporation fails to report gain; when an S corporation fails to determine that a distribution is properly taxable as a dividend; and when a shareholder fails to report non-dividend distributions that are worth more than their stock basis and subject to tax.

With heightened enforcement now a possibility, the tax and reporting structure of clients’ and advisors’ S corporations needs close attention.

For example, S corporation owners who work in their companies have “a significant advantage” over partners in a partnership because flow-through income on Form 1120-S, Schedule K-1, is not subject to self-employment tax, McGrory said. “Conversely, partners who actively perform services for their Form 1065 partnership are subject to self-employment tax on their share of ordinary income that is passed through to them.

“This may motivate some S corporation owners to underpay or not pay themselves W-2 compensation and instead take their compensation through shareholder distributions, avoiding employer and employee FICA and Medicare taxes altogether,” he said.


“Also, shareholders tend to have difficulty tracking and properly calculating their basis in the S corporation,” Forster said. “As a result, shareholders may claim losses and deductions from the S corporation without enough basis to absorb those items. The IRS has been conducting examinations and issuing ‘soft letters’ to shareholders to strengthen compliance.”

McGrory said that in August 2020 the IRS began its newest Compliance Initiative Project (CIP) associated with the lack of officer’s compensation associated with S corporations.

“I recommend to high-net-worth clients who own and work in their S corporations ... pay themselves a reasonable salary,” McGrory said.

McGrory cites the IRS fact sheet on wage compensation for S corporation officers that lists several factors considered by the courts in determining reasonable compensation: duties and responsibilities; time and effort devoted to the business; payments to non-shareholder employees; and what comparable businesses pay for similar services.

Corporations remain in the bull’s eye of tax proposals right now.

“With the new infrastructure plan, choice of entity is likely to become increasingly important, which could influence the focus on S corporations in the future,” Forster said.