Compensation Vertical

IRS tech targets S Corp officer compensation

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The IRS is deploying technology and big data to combat compensation under-reporting, but what does this mean for you and your S Corporation clients? It’s likely that reasonable compensation challenges will occur outside the traditional IRS exam process. A challenge may come from the ongoing Employee Retention Credit or the recently launched Compliance Initiative Project (CIP).

From our polling of professionals, we find most tax advisors and their S Corp clients are dangerously unprepared for an IRS reasonable compensation challenge. If you are working with S Corps, here is what you need to know.

The IRS is currently running two specialty compliance programs that target officer compensation:

  1. The CIP: In August 2020, the IRS began its newest CIP targeting non-payment and underpayment of compensation to officers of S Corps.
  2. Specialty Workstream: The IRS’ first CIP to focus resources on the issue of officer compensation was transitioned into a Specialty Workstream under the Specialty Examination Employment Tax Program focused solely on S Corp officers’ compensation. But it has not gone away.

CIPs are authorized activities, outside of the planned strategies, working to correct noncompliance around particular areas of concern. CIPs operate outside the traditional audit process by focusing on a specific issue, as opposed to a more traditional form 1120-S examination. CIPs identify potential areas of non-compliance within the group or segment, for the purpose of correcting non-compliance. In this case, officer compensation for S Corps.

In 2009, the IRS launched a CIP to address officers’ compensation in response to a scathing GAO report summarizing the IRS’ compliance study launched a few years earlier. The CIP engaged filters to identify high-risk cases, resulting in a drastic increase in reasonable compensation challenges and examinations of S Corps.

Source: TIGTA analysis of the IRS Data Book

Examination rates began to trail off after 2012 for several reasons:

  1. This was the beginning of the IRS’ dark period when they faced mounting PR problems and congressional cutbacks, resulting in drops across the board for all examinations, not just for S corps.
  2. The CIP program was transitioned into the Employment Tax Program as a specialty workstream. As part of this program, examiners were directed to assess paid preparer penalties if an adjustment to reasonable compensation was made. This program continues to this day and is still ensnaring S Corp owners who would typically fall outside of the IRS risk profile for unreasonably low officer compensation.

In August 2020, the IRS began its newest CIP associated with the lack of officers’ compensation associated with S Corps, with the intent to direct even more resources to the issue. The CIP is again focused on improving compliance of S corporations that appear to have not compensated shareholders adequately. These resources include the following:

  • Issue Recommender: A 2018 pilot program called “Issue Recommender” uses algorithms to identify anomalies and commonalities among similarly situated tax returns.
  • Discriminant Function System (DIF): The DIF tax return scoring models measure and grade the risk of noncompliance, and subsequently assign a score to the return based on the potential for overall tax change to the taxpayer’s return.

It’s no longer the luck of the draw if you get challenged; technology is now zeroing in on officer compensation. Being prepared to defend a challenge is all about being proactive. All S Corp officers should have credible research and documentation to support their reasonable compensation calculation. Those who don’t face an uphill defense battle, even if their figure is ultimately determined to be reasonable.

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