When the IRS Challenges Your S-Corp Salary

Part of WageProof's complete guide to S-corp reasonable compensation.

An S-corp salary audit opens with a letter asking how you arrived at the officer compensation figure on the return. If the answer is thin, the examiner builds a figure of their own and bills the payroll tax on the difference, usually with interest dated to the day the tax was originally due and penalties that depend on the facts.

Key takeaways

• A reclassification moves the shortfall onto the W-2 and, because nothing was withheld the first time, generally leaves the business owing both halves of FICA: 12.4% Social Security up to each year's wage base and 2.9% Medicare with no ceiling. Penalties can come on top, depending on the facts: a 20% §6662 penalty for negligence is possible, but it is not automatic.
• TIGTA counted 266,095 single-shareholder returns with profits over $100,000 that reported no officer compensation.
• In the Seventh Circuit the $18,225 Radtke took as dividends came back as wages (Radtke). Watson's $24,000 salary became $91,044 once the government's expert put AICPA survey data in front of the court (Watson, 668 F.3d 1008).
• In Clary Hood the Tax Court allowed only about $3.7 million for 2015 and $1.4 million for 2016 as the CEO's total reasonable pay, against a $5 million bonus in each year, and the Fourth Circuit affirmed the resulting deficiencies while vacating the §6662 penalty.
• The IRS's own reference guide on reasonable pay starts by asking who set the salary, whether records were kept at the time, and whether salary surveys or comparable pay figures were used.

How the IRS flags S-corp salary issues

Returns get scored by machine before anyone at the IRS reads them. The IRS also runs filters that pick out S-corps reporting no officer compensation.

The IRS opened a Compliance Initiative Project (CIP) on officer compensation in 2009 and later folded it into the Employment Tax workstream inside its SB/SE Specialty Examination function. It opened a second, national CIP on the same issue in August 2020. TIGTA Report No. 2021-30-042 (August 11, 2021) counted 12,362 officer-compensation examinations in that workstream between FY 2016 and FY 2018, roughly 4,100 a year. On October 22, 2024, the IRS announced that a dedicated pass-through field operations unit had started work inside its Large Business & International division (IR-2024-276), using Inflation Reduction Act funding to examine partnerships, S-corps and trusts of every size. The announcement said the point was to "reverse our historically low audit rates for complex arrangements employed by certain high-wealth individuals and large entities." About 27% of the agency's Examination and Collection staff then left between fiscal 2024 and fiscal 2025, and the last of its $3.8 billion Inflation Reduction Act enforcement allocation was spent by December 31, 2025 (TIGTA Report No. 2026-3S0-045, August 26, 2026). Because that report does not break out the pass-through unit's headcount, it gives no figure for how many examiners now work the issue.

Of the returns behind the 2021 report, 266,095 came from single-shareholder S-corps with profits above $100,000, zero officer compensation, and $69 billion in distributions across processing years 2016 through 2018. By TIGTA's estimate those returns alone left nearly $25 billion in compensation unreported, and their owners may have avoided roughly $3.3 billion in FICA tax, out of a population where 49.5% of S-corporations report no officer compensation. The same report puts the examination rate at under 1% of S-corps in a given year, and found that nearly half of completed S-corp examinations did not evaluate officer compensation.

Inside the examination

The IRS examines an S-corp's own return in person, usually at the business or its accountant's office, after first making contact by mail. The examiner gathers the facts in an interview or through a written list of requested records called an Information Document Request, and everything the business hands over becomes the file the examiner works from.

Examiners tailor each request to the case. The business should have these records ready, with the market data attached to the duties description:

• A description of the officer's duties, responsibilities and hours worked, and how that time splits across the roles you fill
• Documentation of how the salary was set, and when
• Market data or comparable salary information supporting the figure, with the source identified
• Corporate minutes or board resolutions related to compensation decisions
• Distribution history and the Forms 1120-S, W-2 and K-1 for the years at issue
• The officer's qualifications, training and experience

The IRS's Reasonable Compensation Job Aid for IRS Valuation Professionals is a reference guide for the agency's own valuation staff, and each page says it is not an official IRS position. It asks who set the pay and how, whether salary surveys or comparable pay figures were used, and whether the business kept records of the owner's duties and hours. A market comparison asks what the labor market pays someone else to do the same job. Of the valuation approaches the Job Aid describes, it puts the market approach first and the cost approach last.

Without an analysis that names its data source and shows the arithmetic, the examiner reconstructs it from salary surveys and industry comparisons (IRS experts have also used BLS wage data in Tax Court cases) and a multi-factor reasonableness test whose approach traces to Mayson Mfg. Co. v. Commissioner, 178 F.2d 115 (6th Cir. 1949). Alongside it runs the IRS's list, in Fact Sheet FS-2008-25, of nine factors the courts have considered: training and experience; duties and responsibilities; time and effort devoted to the business; dividend history; payments to non-shareholder employees; the timing and manner of paying bonuses; what comparable businesses pay for similar services; compensation agreements; and the use of a formula to set pay.

The decided cases

David E. Watson, P.C. v. United States, 668 F.3d 1008 (8th Circuit, 2012)

David Watson was a CPA with nearly 20 years of experience and the sole shareholder of an S-corp that held a partnership interest in a well-established accounting firm, where he worked 35 to 45 hours a week as one of the firm's primary revenue producers. In 2002 and 2003, the company paid him a salary of $24,000 a year. The accounting firm paid the company $203,651 in profit distributions for 2002 and $175,470 for 2003, and the company passed what was left after his salary and its expenses to him as dividends.

The Eighth Circuit Court of Appeals affirmed a district court determination that reasonable compensation was $91,044, turning about $67,044 a year into wages subject to FICA. That number came out of AICPA Management of an Accounting Practice (MAP) survey data the government's expert put in front of the court, which adopted his opinion, while no documents showed how the $24,000 had been set.

Joseph Radtke, S.C. v. United States, 895 F.2d 1196 (7th Circuit, 1990)

In 1982 the corporation paid Radtke no salary at all and booked the $18,225 he took out of it that year as dividends. He was an attorney, and his corporation's sole director, shareholder and only full-time employee. Affirming the Eastern District of Wisconsin, the Seventh Circuit held that the payments were remuneration for Radtke's services and therefore wages subject to FICA, whatever the corporation had called them on its books, and it read FUTA the same way.

Clary Hood, Inc. v. Commissioner, No. 22-1573 (4th Circuit, 2023)

A $5 million bonus went to CEO Clary Hood for 2015 and another for 2016, each deducted as reasonable compensation under §162(a)(1) by the South Carolina land excavation and grading company he ran, a C corporation. The IRS called the bonuses excessive and treated them as disguised dividends. The Tax Court gave Hood's experts little or no weight because their reports rested on doubtful assumptions and lacked supporting calculations, and one relied on survey data the court found a poor match for the company's size and the years at issue. It credited the IRS expert, who used survey data on comparably sized site-preparation contractors. It allowed only about $3.7 million for 2015 and about $1.4 million for 2016, producing deficiencies of about $1.96 million across the two years plus a $282,398 accuracy-related penalty for 2016, and the Fourth Circuit affirmed the deficiency determinations while vacating the §6662 penalty.

Clary Hood was decided under §162, the same reasonable compensation standard an S-corp owner is held to, and the expert the court believed was the one who showed complete calculations built on comparable companies. WageProof's market and cost approach reports document the BLS occupation codes, geographic area, data year, and proficiency-to-percentile mapping behind each wage figure, all of it drawn from tables an examiner can open on bls.gov.

Back FICA, penalties and interest

Social Security takes 12.4% of reclassified wages up to an annual wage base of $184,500 for 2026, up from $176,100 in 2025, and Medicare takes 2.9% with no cap, for a combined 15.3%. The salary already paid that year counts toward the wage base, so Social Security reaches only the room left under it. Nothing was withheld the first time, so when the owner already drew some W-2 salary, the business owes both the employee's 7.65% and its own 7.65%. When the owner drew no salary at all, the IRS's examiner manual says a reduced rate generally applies to the employee's share instead, 20% of it under IRC §3509, unless the business intentionally disregarded the rules. Because the wage base resets every January, a reclassification reaching back across two years meets two separate ceilings.

Penalties depend on the facts. Where payroll returns were not filed or the tax was not deposited on time, the IRS can add failure-to-file and failure-to-deposit penalties under IRC §6651 and §6656, the two the Tax Court upheld in Glass Blocks Unlimited (T.C. Memo. 2013-180). Where a payroll return was filed, the IRS can also add a 20% accuracy-related penalty for negligence under IRC Section 6662. That penalty is not automatic, and reasonable cause is a defense to it.

Interest usually runs from the date the payroll tax was originally due rather than from the date of the notice, so a year the IRS opens four years later can arrive with about four years of interest already on it. Under IRC Section 6621, the underpayment rate is the federal short-term rate plus 3 percentage points, reset quarterly and compounded daily. Each day's interest is added to the balance the next day's is figured on. The rate rose to 7% for the third quarter of 2026 from 6% in the second, and the IRS has held it at 7% for the fourth. Interest can be avoided in one case. If the business agrees to the examiner's figures on Form 2504, the IRS form for agreeing to additional payroll tax, and pays the tax by the time it files that form, the correction can be interest-free. That relief is not available if the same issue came up in an examination of an earlier period, if the business knowingly underreported, or once the IRS has assessed the tax and demanded payment.

Each underpaid year is assessed on its own. In Watson the same $67,044 of reclassified wages recurred in every year the government examined, with a separate penalty and a separate interest clock behind each. The Employment Tax workstream's average result was about $17,726 per return examined (TIGTA Report No. 2021-30-042, FY 2016 through 2018).

Reasonable compensation reports for CPAs and EAs give the return preparer a dated, sourced analysis for each client's file.

How to prepare before the IRS asks

A report from three tax years ago supports the salary the owner paid that year and nothing since, because BLS publishes new wage estimates every year and duties shift as a business grows. Any analysis has to name the occupation you actually perform, your geographic area and your experience level. Each goes into the report, where the examiner can open the same published table without taking your word for the inputs. An analysis finished before the return was filed records what you believed the job was worth on the day you set the salary, and that day is the one the examiner's question is about.

Most of the document request comes out of records you already keep: corporate minutes, the distribution history, the Forms 1120-S, W-2 and K-1. The board resolution approving the salary usually has to be written from scratch, and it needs the figure, the date it was approved, a line recording that it was reviewed against market data, and a place in the minute book even when you are the sole shareholder and the board is you. Name the analysis in that line by its date and its data source, so the resolution and the report point at each other when an examiner reads them together. A duties-and-hours description rarely exists on paper either, and a page on what you do and roughly how the week splits will carry it. Qualifications and training you can answer from the license, the degree and the years already spent in the field, without writing anything new.

When your week runs across executive work, billable production, sales and administration, write the split down; rough numbers are fine. A report built on that split weights the wage benchmarks to the hours behind each role. The reasonable salary calculator shows how WageProof prices each role.

If none of that exists yet, WageProof assembles it from BLS data in about 15 minutes, and the sample report shows the document an examiner would receive.