Since compensation is subject to employment taxes (i.e., primarily Social Security and Medicare taxes) and distributions to shareholders are not, many S corporation owners reduce their compensation and increase their shareholder distributions in an attempt to avoid the employment taxes. In some cases this is justifiable, and in some it is not. The IRS is well aware of this issue; in fact, one of the IRS’s hottest audit triggers for S corporations is insufficient compensation paid to employee-shareholders.
The Journal of Accountancy recently published an article that provides nine steps to help S corporations reduce the likelihood of an IRS examination for unreasonable owner compensation. Read the article here.