Report Card:
A couple of weeks ago, the Treasury Inspector General for Tax Administration (“TIGTA”) released a report that presented the results of its review to determine whether the IRS’s “policies, procedures and, practices” adequately ensured that its examiners were considering the compensation paid by closely held S corporations to those shareholders who rendered service to the corporations.[i]

Let’s just say the IRS did not receive a stellar grade.[ii]

For the years examined, TIGTA found that the IRS selected less than one percent of all S corporations for a so-called “field examination” which is conducted by an IRS revenue agent who will visit the corporation’s location where its books and records are located. Business returns, including those filed by S corporations, are always subject to field exams.

According to TIGTA’s report, when the IRS did examine S corporation returns, nearly half of the examinations completed did not consider the question of officers’ compensation and the payment of employment taxes with respect thereto.

Indeed, even in the case of single-shareholder S corporations that reported substantial gross receipts and no officers’ compensation, but significant amounts of distributions,[iii] the IRS failed to evaluate whether any portion of such distributions should have been considered compensation instead.


My own experience with S corporations and their owners bears out the concerns underlying the findings set forth in TIGTA’s report.

One of the first items I request at the start of an engagement that includes an S corporation is a copy of the corporation’s most recently filed federal income tax return.[iv]


This return, together with related filings (including the shareholders’ tax returns, among others) provide a wealth of information regarding the corporation and its business. Included on the first page, for example, is how many shareholders there were during the taxable year, plus the total amount of compensation paid to the corporation’s officers. The corporate return should include another form[v] which reports not only the total compensation paid to each officer, but also whether the officer is a shareholder and the officer’s percentage ownership in the corporation. This form also indicates whether any portion of officers’ compensation is deducted elsewhere on the corporation’s tax return – meaning other than as a standalone expense incurred in the ordinary course of business[vi] – including for example, in cost of goods sold.[vii]


Having checked out the compensation, if any, paid to shareholder-employees,[viii] I then turn to those schedules on the corporation’s return that report information regarding distributions[ix] and loans made by the corporation to its shareholders.[x] These provide a sense of how the shareholders are removing value from their corporation other than as – sometimes in lieu of – compensation.

Passive Activity

My preliminary review ends with a look at the shareholders’ tax returns[xi] – did they report their share of S corporation income as passive or nonpassive income; was this income subject to the surtax on net investment income, meaning did it arise from a passive activity as to the shareholder? If the shareholder reported the income as non-passive or if they omitted the income from the tax base for net investment income,[xii] did the corporation pay them any compensation? What about distributions or loans?[xiii]


As you can see, there are several spots in an S corporation’s and in an individual shareholder’s respective tax returns which may appear to contradict each other. After all, how can a shareholder-officer be materially engaged in the corporation’s business but not receive a salary?

In some cases, this is because one tax professional prepared the corporation’s returns while another prepared the individual shareholder’s returns. The latter will often take a position that is “beneficial” to their client, albeit unsupported by the facts; for example, one that does not subject the client to the tax on net investment income, notwithstanding the corporation has determined that this shareholder is not sufficiently involved in the business to merit a salary.[xiv]

In other situations, the return preparer for the corporation may have included the compensation in cost of goods sold[xv] or as a component of the costs considered in determining net rental real estate income[xvi] in the case of an S corporation engaged in such business.

In fact, according to the TIGTA report, “It is possible for an S corporation to misclassify officer’s compensation and include it as another expense (such as salaries and wages, cost of labor in Cost of Goods Sold, or other deductions).”

Why Care?

Why should TIGTA and the IRS care about S corporation shareholder compensation?

The shareholders of an S corporation are not subject to employment taxes under the Self-Employment Contributions Act (SECA) with respect to their respective shares of S corporation income.

This is so notwithstanding the S corporation is a pass-through entity: its items of income, gain, deduction and loss flow through to its shareholders who include such items in determining their own income tax liability;[xvii] the character of any item included in a shareholder’s pro rata share is determined as if such item were realized by the shareholder directly from the source from which realized by the corporation, or incurred in the same manner as incurred by the corporation[xviii]; the corporation itself is generally not subject to income tax.[xix]

Distributions made by an S corporation to its shareholders in respect of their shares in the corporation are also not subject to employment taxes.[xx]  These are deemed to represent a return on a shareholder’s investment rather than compensation for an employee’s services.

However, wages paid by the S corporation to a shareholder-employee are subject to employment taxes and withholding in accordance with the Federal Insurance Contributions Act (FICA).

Many S corporations have exploited the foregoing circumstances to avoid the payment of employment taxes. A corporation’s shareholder-employees may choose not to pay themselves any compensation for their services to the corporation even though a non-shareholder service provider, including an employee, would have required payment of compensation in an amount commensurate with the value of the service rendered (i.e., reasonable compensation).

Eventually, the IRS published a ruling in which it determined that shareholder-employees of an S corporation could not avoid employment taxes by paying themselves less than a reasonable amount of compensation while also taking dividend distributions from the corporation. In that case, the IRS ruled that it would recharacterize part of the distributions as compensation income that was subject to employment taxes.[xxi]

Today, the instructions to the S corporation return are clear in that distributions and other payments by an S corporation to a corporate officer should be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.[xxii]

TIGTA’s Recommendation

Distinguishing among distributions, loans and compensation flowing from an S corporation to a shareholder is consequential.

For the relatively short period of the study, TIGTA estimated that approximately $25 billion in compensation may not have been reported by S corporations, with a resulting loss in billions of FICA tax.

To address this situation, TIGTA recommended that the IRS “evaluate the risk of noncompliance associated with officer’s compensation in S corporation returns and update the examination plan.”

The IRS did not agree with the recommendation. Call it bureaucratic inertia or perhaps some form of circling the wagons.

Whatever. In the end, it may not matter in light of developments in Pres. Biden’s Washington.

Pending Legislation

Individuals with incomes over a threshold amount are subject to a 3.8 percent tax on their net investment income.[xxiii] Among other things, net investment income includes income derived from a trade or business in which the taxpayer does not materially participate, and net gain from the disposition of property other than property held in a trade or business in which the taxpayer materially participates.[xxiv] The net investment income tax (NIIT) does not apply to self-employment earnings.

Self-employment earnings and wages are each subject to employment taxes under either SECA or FICA, respectively. Both SECA and FICA taxes apply at a rate of 12.4 percent for social security tax on employment earnings (capped at $142,800 in 2021) and at a rate of 2.9 percent for Medicare tax on all employment earnings (not subject to a cap). An additional 0.9 percent Medicare tax is imposed on self-employment earnings and wages of certain high-income taxpayers.

One goal of the President’s American Families Plan is to ensure that all pass-through business income of “high-income” taxpayers – including covered shareholders of S corporations – is subject to either the 3.8 percent NIIT or the SECA tax.

Under the proposed legislation – which is currently being drafted and is scheduled to be submitted to the House by mid-to-late September – all business income of high-income taxpayers would be subject to the 3.8-percent Medicare tax, either through the NIIT or the SECA tax.

In particular, for taxpayers with adjusted gross income in excess of $400,000, the definition of net investment income would be amended to include gross income and gain from any business that is not otherwise subject to employment taxes. In the case of an S corporation shareholder who does not materially participate in the corporation’s business, this would include the shareholder’s share of S corporation income.

An S corporation shareholder who materially participates in the corporation’s business – and, thus, is currently exempt from the NIIT, though they should be receiving compensation from the corporation for their services that is subject to FICA tax – would be subject to SECA taxes on their distributive share of the business’s income (presumably after accounting for any wages and FICA taxes) to the extent that this income exceeds certain yet-to-be announced threshold amounts.

If enacted,[xxv] the foregoing proposals would be effective for taxable years beginning after December 31, 2021.

And you thought “the only thing we have to fear is”[xxvi] income taxes. Ha!

Stay tuned S corporation shareholders.

[i] . TIGTA’s mission is to “provide quality, professional audit, investigative, and inspection and evaluation services that promote integrity, economy, and efficiency in the administration of the Nation’s tax system.” Pretty highfalutin, isn’t it?

[ii] Query how it felt to be on the other side of an exam?

[iii] Almost always a red flag.

[iv] On IRS Form 1120-S, U.S. Income Tax Return for an S Corporation.

[v] IRS Form 1125-E, Compensation of Officers.

[vi] Which is reflected as a separate item on the first page of the corporation’s tax return.

[vii] IRS Form 1125-A, Cost of Goods Sold includes a line for “cost of labor” which is capitalized as part of the cost of goods sold. The first page of Form 1120-S reports the total amount of cost of goods sold.

[viii] Officers are generally treated as employees of the corporation.

[ix] IRC Sec. 1368.

[x] Shareholders’ Pro Rata Share Items (Sch. K), the Balance Sheet (Sch. L; especially loans to shareholders), the Accumulated Adjustments Account (Sch. M-2), and the Sch. K-1 issued to each person who was a shareholder during any part of the taxable year.

[xi] Part II of Sch. E of IRS Form 1040 tells us whether the shareholder is reporting their share of S corporation as passive or nonpassive income. This is followed up by checking the shareholder’s IRS Form 8960, Net Investment Income Tax, to see whether the shareholder has reported their share of S corporation income as non-section 1411 income, which is not subject to the 3.8% tax, meaning the shareholder has materially participated in the corporation’s business.

[xii] IRC Sec. 1411.

[xiii] How many times have you seen the loan amount to a shareholder increase year over year, while no distributions are made, and little-to-no compensation is paid? Plenty, right? In those situations, how often have the parties executed a loan agreement or otherwise acted as bona fide lenders and borrowers? Few and far between, I bet. They don’t even bother to impute interest under IRC Sec. 7872. Drives me mad.

[xiv] Such inconsistent reporting probably does not fall within the scope of IRC Sec. 6037(c) which requires that a shareholder’s tax return treat “subchapter S items” in a manner which is consistent with their treatment on the corporation’s tax return. The shareholder must identify any inconsistent treatment to the IRS. See IRS Form 8082, Notice of Inconsistent Treatment.

[xv] IRS Form 1125-A.

[xvi] See IRS Form 8825, Rental Real Estate Income and Expenses of a Partnership of an S corporation – there is a line for wages and salaries.

[xvii] IRC Sec. 1366(a).

[xviii] IRC Sec. 1366(b).

[xix] IRC Sec. 1363. One exception resides in IRC Sec. 1374 and the so-called “built-in gain” rules.

[xx] Of course, the distribution may be subject to income tax if, for example, the corporation has earnings and profits from tax years during which it was a C corporation.

[xxi] Rev. Rul. 74-77. Query whether this ruling would apply if no distributions had been made. I believe the ruling should be extended to that situation. Doing so would represent merely an extension of the arm’s length standard that permeates the tax treatment of transactions between related persons. See Reg. Sec. 1.482-1.

[xxii] The argument for a single shareholder not reporting compensation and receiving a tax-free distribution is especially difficult. Reasonableness is important, and it is possible that something less than the entire distribution may represent compensation; however, it is difficult to escape the conclusion that a sole shareholder who receives only distributions is actually receiving compensation without paying employment taxes.

[xxiii] IRC Sec. 1411.

[xxiv] IRC Sec. 1411(c).

[xxv] The odds are better than even at this point.

[xxvi] Yes, from FDR’s first inaugural speech, in 1933:

“So, first of all, let me assert my firm belief that the only thing we have to fear is…fear itself – nameless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into advance. In every dark hour of our national life, a leadership of frankness and of vigor has met with that understanding and support of the people themselves which is essential to victory. And I am convinced that you will again give that support to leadership in these critical days.”