We often hear business owners say things like:
• “I’ve never had a problem with my S-Corp.”
• “I don’t plan to take reasonable compensation.”
• “The IRS has never questioned my numbers.”
If any of these sound familiar, it may be time for a reality check. S-Corp audits can seem rare until they happen to you. The truth is that the IRS is paying much closer attention to reasonable compensation issues, and the cost of ignoring this area can be far higher than you expect.
At our firm, we’ve seen firsthand how easily a well-meaning taxpayer can end up in trouble. Here’s a real-world example that illustrates how quickly an oversight can lead to serious financial consequences.
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The Case: When “It Won’t Happen to Me” Became “It Just Did”
Tax Year: 2022
Business Type: Personal shopping and delivery service
Entity Structure: Single-shareholder S-Corporation with no employees
Compensation: $0 paid in wages
Distributions: $60,000
Despite clear guidance from their CPA to pay themselves reasonable compensation, the shareholder declined, hoping to minimize tax liability. Unfortunately, that decision drew the IRS’s attention. A specialized payroll group within the Small Business/Self-Employed division selected the return for review, suspecting that the shareholder had improperly classified wages as shareholder distributions.
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The Cost of Ignoring Reasonable Compensation
The IRS examiner proposed reclassifying the full $60,000 in distributions as wages. Since wages are subject to 15.3% in payroll taxes, that alone generated a $9,180 tax liability. Once penalties and interest were added — roughly 2.5 times the payroll tax — the total bill for 2022 came to approximately $23,000.
As if that weren’t enough, the examiner also indicated plans to audit the following two years, 2023 and 2024, when distributions had increased significantly (around $220,000 per year). The potential exposure was enormous.
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Why the IRS Is Paying More Attention
The IRS has made S-Corp compensation a major enforcement priority. With expanded funding and more examiners, agents are actively targeting S-Corp shareholders who pay themselves little or nothing while taking substantial distributions.
In this case, the shareholder’s biggest mistake wasn’t just ignoring professional advice — it was underestimating the IRS’s authority to reclassify income, assess back payroll taxes, and impose severe penalties.
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A Possible Resolution
Once the audit began, the shareholder’s CPA prepared a detailed reasonable compensation analysis using an industry-based cost approach. The analysis supported the idea that $60,000 was a reasonable annual wage for the shareholder’s role and responsibilities.
If the IRS accepts this conclusion, the taxpayer can use it as a foundation for future years, limiting the total liability (including penalties and interest) to about $65,000 — a significant but manageable outcome compared to what could have been much worse.
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When Things Could Escalate
If the IRS determines that the shareholder’s services were worth significantly more — say $100,000 per year — the financial consequences rise steeply:
• 2022: Roughly $23,000 in taxes and penalties (unchanged, since only $60,000 was distributed).
• 2023 and 2024: About $40,000 per year, based on recharacterized wages of $100,000.
That totals close to $100,000 in back taxes, penalties, and interest across three years. Even more concerning, one audit can lead to broader scrutiny of a preparer’s other clients.
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Key Lessons for S-Corp Owners
The best protection against an S-Corp audit is documentation and preparation. The IRS expects every shareholder-employee to pay themselves reasonable compensation based on:
1. The Shareholder’s Actual Role – Compensation should align with the work performed, skill level, and hours devoted to the business.
2. The Source of the Company’s Income – If business profits primarily come from your personal services, a higher wage is justified.
Here’s how to stay compliant:
• Conduct a Compensation Analysis Annually: Document your role, responsibilities, time commitment, and market-based wage data each year.
• Work Closely with Your CPA: A qualified professional can help you calculate an appropriate salary and recognize potential audit triggers before they arise.
• Avoid Complacency: Even if you’ve never been audited, the IRS is focusing heavily on this issue. Treat every tax year as if it might be reviewed.
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The Real Cost of “Rolling the Dice”
This issue isn’t just about payroll taxes — it’s about the long-term health of your business. Ignoring reasonable compensation rules can result in tens of thousands of dollars in penalties, back taxes, and professional fees.
For CPAs, there’s also exposure to paid preparer penalties of up to $60,000 per year if the IRS believes a preparer “should have known better.” Once a case is opened, it can invite scrutiny of other client files as well.
Fortunately, these risks are entirely avoidable. With clear documentation and a defensible compensation strategy, you can demonstrate compliance and drastically reduce your audit risk.
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Protect Your Business and Your Peace of Mind
While the odds of an S-Corp audit may seem low, the risks are too great to ignore. Paying yourself a reasonable, well-supported salary is one of the simplest ways to protect your business, your finances, and your reputation.
If you’d like assistance determining a defensible compensation level or preparing proper documentation for your S-Corp, our team can help. A proactive approach today can prevent costly issues down the road — and give you peace of mind that your business is fully compliant.

Sincerely,
W. E. Stevens, PC

Serving you through a thoughtful client experience, wise long-term perspective, and very experienced staff