S-Corporations and Salary

In 2004 and now again in 2007 the IRS is closely focusing on the S-Corporation. 

The S-Corporation, since it's creation, has been a tax savings vehicle, advantaged over Partnerships and Sole Prop's, by the lack of Self-Employment Taxation on the flow thru of income not taken as salary.  Unfortunately, like everything else good in life, some people began to take advantage of this opportunity.  Some business owners were taking no salary at all, and all their income as draws/k-1/flow thru income paying no self-employment tax on the income they earn.

The IRS specifically audited a small percentage of the S-Corporation tax returns in the 2004 tax year to determine if salaries were "reasonable" or at minimum followed the unspoken rule of a 50/50 split between salary (W-2) and flow thru income (K-1).  There were many cases where business owners had the money that they earned reclassified as salary, due to the IRS with penalties and interest!

Audits are never fun, so for the new round of audits, business owners should make sure to speak with their CPA regarding the owner's compensation levels and the amounts of flow thru income taken.