Reasonable Compensation Horror Stories: The Tax Man Cometh

Most S corporation owners know the rule: if you work in your corporation, you must pay yourself a reasonable salary before taking the rest of your profits as distributions.

Fewer realize the owner is not the only one exposed when the salary is missing. The tax return preparer can be penalized too, on a per-return and per-year basis.

In the reprinted article below, tax attorney Eric L. Green tells the story of a CPA who never ran his clients’ payroll or kept their books, and who had urged them for years to take salaries. The IRS still assessed $130,000 in preparer penalties across 13 clients and two tax years, and the CPA ended up $34,500 out of pocket.

The tax years in the story are older, but the penalty rules have not changed, and neither has the low-salary incentive that caused the problem. In 2026, wages carry a combined 15.3 percent payroll tax up to the $184,500 Social Security wage base, which creates and maintains the temptation to keep that salary low.

The following article by Eric L. Green, Esq., originally appeared on the RCReports blog on November 1, 2022, and is reprinted with permission.

When my office phone rings at 5:30 on a Friday afternoon, you know it’s probably bad. This particular call was no exception. On the other end of the line was Bob, a CPA I had known for years. “Counselor,” he started, “I have a real problem.”

“Okay, Bob, what’s the problem?”

“The IRS audited a few of my S corp clients and then expanded to a few more. They claim my clients should have been taking a reasonable salary.”

I agreed with that. “How much salary did the clients take?”

“Most took none, a few took a little. I have been harassing them for years to take a reasonable salary, but they don’t listen,” said Bob. “I don’t do their payroll or books, just the return when they send me their stuff. The auditor kept insisting that they have a written report for justifying their salary. Who does that?”

“What’s the bottom line?” I asked.

“They are penalizing me $1,000 per client for understatement of tax due to an unreasonable position under Internal Revenue Code 6694(a) and another $4,000 each for understatement of tax due to a willful or reckless conduct under 6694(b).”

“So $5,000 each. For how many clients?” I asked, wincing at the number.

“Thirteen.”

“So $65,000 in preparer penalties?” I confirmed, shocked.

“No, Eric. That’s just for 2009. They did the same for 2010. It’s $130,000 in penalties,” finished Bob with a whimper.

Ever since this conversation, I have been a proponent of securing the written report that supports the “reasonable compensation” that our clients decide to take from their company. Bob was charged with $130,000 of penalties despite not doing the clients’ books, running their payroll, or having anything to do with their financial decisions around compensation.

If you have never been in this position, congratulations, and because you are reading this, hopefully you never will be. However, practitioners charged with preparer penalties MUST challenge them. Failure to do so is considered an admission and leaves the practitioner open to having their ability to practice before the IRS stripped from them by the IRS’s Office of Professional Responsibility. That’s a topic for another blog post.

To challenge the penalty, the tax professional must pay 15 percent and then file for a refund of the amount paid. So, in our case above, Bob ended up paying $9,750 for both 2009 and 2010. A total of $19,500 paid to the government just to challenge the issue!

My firm took a $15,000 retainer and filed a claim for refund in the federal district court. In our complaint with the United States district court, we raised the following arguments:

• The tax returns prepared for the tax preparation clients were correct as filed based on the information provided by each client.

• The IRS cannot require a tax preparer, such as plaintiff, to create a “reasonable salary” for the shareholder-employee of a subchapter-S corporation after the close of the applicable tax year, as only the IRS can make such determinations.

• It is the commissioner of the IRS, not the tax professional preparing the return after the fact, who has the authority to treat other distributions as salary.

Despite reasonable arguments, the Department of Justice does not generally roll over on these assessments, and they did not in Bob’s case.

After months of going back and forth, all the while costing Bob legal fees, the Department of Justice agreed to drop its claims if Bob would surrender his claim to the 15 percent, or $19,500, he had paid in to start the refund action. Bob, who wanted this nightmare to end, chose to stop the financial bleeding and settle according to their terms.

Adding in his $15,000 in legal fees, this misadventure cost him $34,500, none of which he could recover.

Since this case, every corporate client with whom my firm is involved is advised to get a reasonable compensation report. We acknowledge the expense, but as Bob found out, the expense of NOT getting the report can be much, much higher when the tax man cometh.

Eric L. Green, Esq., is one of the managing partners of Green & Sklarz LLC, where he focuses his practice on civil and criminal taxpayer representation, and he is the founder of Tax Rep Network, where he coaches accountants and attorneys on building their IRS representation practices.

RCReports creates reasonable compensation reports for tax professionals and business owners.

Takeaways

• An S corporation shareholder who performs substantial services for the corporation must receive reasonable wages, and the IRS can recharacterize distributions as wages when the salary is too low.

• The preparer’s exposure is separate from the client’s. A return reflecting an unreasonable position can cost the preparer the greater of $1,000 or 50 percent of the income from preparing it. Willful or reckless conduct raises that to the greater of $5,000 or 75 percent, reduced by any penalty under the first rule.

• The penalties apply per return and per year, so a practice with many S corporation clients can reach six-figure penalties quickly, as Bob’s did.

• To contest the penalty without paying all of it, the preparer must pay at least 15 percent within 30 days of notice and must file a refund claim, then sue in district court if the claim is denied.

• Document the salary decision in writing before the year closes, and put your salary advice to clients in writing, too. Neither guarantees a win, but both steps answer the question the auditor in this story kept asking: Where is the written justification?