Reasonable Compensation Audits: The Hidden Risk for Roseville S-Corp Owners

The S-Corporation is the entity of choice for many small businesses in Roseville, from medical practices on Douglas Blvd to tech consultants in Rocklin. The primary tax advantage is obvious: you don’t pay self-employment tax (Social Security and Medicare) on the profits (distributions) of the business, only on your wages.

Naturally, this creates an incentive to pay yourself a tiny salary and take a huge distribution. For example, a consultant earning $200,000 might try to pay themselves a $30,000 salary and take $170,000 as a distribution, saving roughly $20,000 in taxes.

The IRS is onto this. And in 2025, they are cracking down.

The “Reasonable Compensation” Standard

The law requires S-Corp shareholder-employees to pay themselves a “reasonable salary” for the services they provide. If the IRS audits you and determines your salary was artificially low, they will recharacterize your distributions as wages.

The consequences of this recharacterization are severe:

• Back Payroll Taxes: You will owe the employer and employee portion of FICA taxes on the recharacterized amount.
• Penalties and Interest: Failure to deposit payroll taxes carries hefty penalties.
• Loss of QBI Deduction: Changes to your wage income can negatively impact your Qualified Business Income deduction (Section 199A), leading to income tax adjustments as well.

How to Determine “Reasonable”

There is no single number, but “I wanted to save money” is not a defense. The IRS looks at:

• Training and Experience: Are you a veteran attorney or a fresh intern?
• Duties and Responsibilities: Do you manage the staff, do the marketing, and perform the service? You need to be paid for all those hats.
• Time and Effort: Do you work 60 hours a week or 10?
• Comparable Data: What would it cost to hire someone else to do your job in Roseville?

Defending the Audit

If you are selected for a Reasonable Compensation audit, Kugelman Law can help. We use industry salary data and legal precedents to justify your compensation structure. Perhaps your business had a down year, justifying a lower salary. Perhaps your high distributions were actually a Return on Capital (ROI) for your significant investment in equipment, not payment for your labor.

We help you build the narrative that supports your numbers. Furthermore, we can help you conduct a “Compensation Study” now to protect your returns for future years.

Don’t gamble with payroll taxes. Ensure your S-Corp is compliant and audit-proof with the help of Kugelman Law.