IRS Warning: Reasonable Compensation Audits for High-Earners Imminent

The Internal Revenue Service (IRS) has recently issued a warning about imminent audits targeting high-earners regarding reasonable compensation. The IRS aims to ensure that S Corporation owners and other high-income taxpayers are not underreporting their income by paying themselves unreasonably low salaries. This renewed focus underscores the importance of compliance and the potential consequences of failing to meet IRS standards.

Understanding Reasonable Compensation

Reasonable compensation refers to the salary that owner-employees of S Corporations or closely-held corporations pay themselves. According to the IRS, this compensation should be comparable to what a business of similar size, industry, and location would pay for similar services. The IRS scrutinizes companies suspected of paying unreasonably low salaries to their owners to reduce employment taxes, which fund Social Security, Medicare, and unemployment insurance.

Why the Crackdown on Reasonable Compensation?

The IRS's enhanced focus on reasonable compensation involves several underlying reasons:

• Employment Tax Revenue: The IRS aims to maximize employment tax revenue by ensuring that salaries are set at appropriate levels. Underreporting income through low salaries results in reduced tax collections.
• Fair Tax Code Enforcement: High-earners taking unreasonably low salaries while benefiting from corporate profits are not abiding by fair tax practices. The IRS seeks to level the playing field.
• Funding Needs: Increased funding needs for federal programs place pressure on the IRS to ensure fair tax contributions from all taxpayers, especially high earners.
• Audit Effectiveness: These audits are a powerful tool to deter others from attempting similar tax avoidance strategies. Focusing on a few high profiles can have a broader compliance effect.

Red Flags That Might Trigger an Audit

High-earners and their accountants need to be vigilant about certain red flags that could trigger an IRS audit:

• Low S Corporation Salaries: Classifying most of one's income as distributions instead of wages can draw suspicion.
• Substantial Profits and Low Salaries: Businesses reporting significant profits but paying their owners minimal salaries are likely scrutiny targets.
• High Dependency on Dividends: High reliance on dividends rather than salary could be viewed as a deliberate attempt to lower tax liabilities.
• Industry Comparisons: Salaries significantly lower than industry standards for similar roles and companies will raise eyebrows.

How to Prepare for a Reasonable Compensation Audit

Preparation is key to enduring IRS scrutiny without detrimental consequences. Heres how you can align your practices with IRS expectations:

• Document Salary Decisions: Maintain thorough documentation of how salary figures are determined, including industry benchmarking and comparisons.
• Use Independent Studies: Obtain third-party salary studies to substantiate your compensation practices. Independent reports can serve as solid evidence in case of queries.
• Consult Professionals: Work closely with tax professionals or legal advisors to ensure your compensation practices are compliant and well-documented.
• Review Regularly: Periodically review and adjust salaries to reflect changes in roles, industry standards, and the company's financial health.
• Be Transparent: Clear, transparent communication with the IRS, if audited, can mitigate risks and potential penalties.

The Consequences of Non-Compliance

Failing to meet reasonable compensation standards comes with potential consequences, including:

• Back Taxes: Payment of accrued back taxes on income that should have been reported as salary plus interest.
• Penalties: Severe penalties for misreporting income, which could include fines up to 25% of the underreported amount.
• Increased Scrutiny: A history of violating compensation rules may lead to increased future scrutiny from the IRS, making future audits more likely.
• Damage to Reputation: Audits and penalties can damage a business's reputation, affecting relations with clients, partners, and financial institutions.

Conclusion: Act Now to Protect Your Finances

In light of the IRS's increased focus on reasonable compensation, high-earning taxpayers and S Corporation owner-employees need to review and possibly revise their compensation structures. Ensuring compliance can help you avoid costly audits and penalties. Furthermore, working with knowledgeable tax professionals can provide peace of mind and strategic advantages.

To learn more about how you can save on taxes and ensure compliance with IRS regulations, set up a call with our team today.