Treasury watchdog: Focus on S corps and shareholder compensation

Sep 30, 2021

The Treasury Inspector General for Tax Administration (TIGTA) recently summarized its findings concerning efforts by the IRS to identify S corporation reasonable compensation issues. The report concludes that the IRS is likely failing to adequately identify S corporations that are underreporting their shareholders’ compensation in an effort to avoid employment taxes. Interestingly, in its response, the IRS largely disagreed with the inspector general’s conclusions and its related recommendations.

What TIGTA Found & Recommended

The TIGTA’s report concludes that the IRS selects S corporation returns for review at an extremely low rate (0.2% of all S corporation returns were subject to a field exam during fiscal years 2017-2019). It further concludes that during those field exams, officers’ compensation was examined at a rate less than the estimated general population compliance risk. The report notes that even in cases where S corporations had a single shareholder owner and did not report any officer compensation, field agents routinely failed to select these returns for examination.

As such, the TIGTA recommended that the IRS more thoroughly evaluate the risk of noncompliance on this issue and update its examination plan to increase the likelihood of identifying the issue.

Beyond field examinations, the report also recommended the IRS leverage recent compliance initiative projects under the employment tax division that are aimed at identifying S corporation returns with officer compensation issues, as well as evaluate using compensation thresholds and related quantitative criteria to help identify the issue for field examination.

IRS Response

The IRS largely dismissed the TIGTA’s recommendations, instead expressing confidence in its current policies and procedures and suggested that its assessment of noncompliance risk was likely more accurate than that of the TIGTA. In response to the TIGTA’s recommendations, the IRS: a) expressed confidence in its existing examination plan and its ability to identify the compensation issue, b) dismissed the use of compensation thresholds, asserting that revenue agents were adequately trained to identify the issue, and c) indicated that it already uses results from other established workstreams to inform their actions.

Practical Insights and Potential Impacts – Reading the Tea Leaves

The IRS’ rejection of the recommendations is interesting. Superficially, the IRS responses seem to indicate it is happy with the status quo. However, a closer read of the TIGTA report in conjunction with the IRS’ responses might signal that the IRS is already looking at the issue, perhaps more carefully now as part of other compliance campaigns.

Certain comments in the report may provide insight into how the IRS is thinking about the issue. Specifically, the TIGTA report references a new project created by the IRS in August 2020, “to focus additional resources on the issue of officer’s compensation associated with S corporations.” Although the TIGTA report redacted the project’s quoted objective, references elsewhere in the report to this new August 2020 program allude to a possible focus on compensation and distributions.

So, while the IRS disagreed with the form of the TIGTA recommendations, it may not necessarily disagree with the underlying substance or point of the recommendations – i.e., how to better identify issues with S corporation officer compensation for examination. This remains an important item for S corporations to consider, as it is clear that the IRS continues to focus on the issue.

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