S-Corp Tax Mistakes That Trigger IRS Audits

(And How to Avoid Them)

Electing S-Corporation status for your business can provide significant tax advantages, including avoiding double taxation and potentially reducing self-employment taxes. However, these benefits come with strict compliance requirements that the IRS monitors closely. When S-Corp owners cut corners or misunderstand the rules, they often find themselves facing audits, penalties, and back taxes that far exceed any savings they hoped to achieve.

As an Enrolled Agent based in Whittier, Los Angeles County, California, I work with S-Corp owners across the country who have run into IRS problems—often because of preventable mistakes. Whether your S-Corp is based in California or you’re operating in multiple states, understanding these common pitfalls can help you stay compliant and keep more of what you earn.

This guide covers the most frequent S-Corp tax mistakes that attract IRS attention, explains why the agency targets these issues, and provides practical steps to protect your business.

What Is an S-Corporation and Why Does the IRS Scrutinize Them?

An S-Corporation is a tax election that allows business income to pass through to shareholders’ personal tax returns, avoiding the corporate-level taxation that C-Corporations face. For many small and medium-sized businesses, this structure offers meaningful tax savings—particularly when it comes to self-employment taxes.

Here’s where the IRS concern comes in: the S-Corp structure creates opportunities for tax minimization that, if misused, cross the line into non-compliance. The agency knows that some business owners exploit these structures to underreport income, avoid payroll taxes, or take improper deductions. As a result, S-Corps face higher audit rates than many other business structures.

The good news is that legitimate S-Corp tax planning is perfectly legal. The key is understanding where the boundaries are and staying well within them.

The Reasonable Compensation Problem: The Number One S-Corp Audit Trigger

What Is Reasonable Compensation?

If you’re a shareholder-employee of an S-Corp, the IRS requires you to pay yourself a “reasonable salary” for the services you provide to the business. This salary is subject to payroll taxes—Social Security and Medicare—just like any other employee’s wages.

The remaining profits can be distributed to you as shareholder distributions, which are not subject to self-employment taxes. This is where the tax savings come from—and where many S-Corp owners get into trouble.

Why Do S-Corp Owners Underreport Salaries?

The temptation is straightforward: pay yourself a minimal salary and take the rest as distributions to minimize payroll taxes. If your S-Corp generates $200,000 in profit and you pay yourself a $40,000 salary, you’re only paying FICA taxes on that $40,000. The remaining $160,000 comes to you as distributions without additional employment taxes.

The problem? The IRS considers this arrangement abusive if your salary doesn’t reflect what you’d pay someone else to do the same work. And “reasonable” isn’t a suggestion—it’s a legal requirement.

How Does the IRS Determine Reasonable Compensation?

The IRS looks at several factors when evaluating whether a shareholder-employee’s compensation is reasonable. These include the training and experience required for the position, the duties and responsibilities involved, the time devoted to the business, comparable salaries for similar positions in the same geographic area, the company’s dividend history, and the overall compensation packages at comparable businesses.

If you’re an MD, medical doctor, running a medical clinic through an S-Corp, paying yourself $60,000 when other MDs in your area earn $200,000 or more will raise immediate red flags.

What Happens If You’re Caught?

The IRS can reclassify your distributions as wages, requiring you to pay back payroll taxes plus penalties and interest. In some cases, I’ve seen clients face tax bills exceeding what they “saved” over multiple years of underpaying themselves. The penalties for employment tax violations can be particularly severe, and in egregious cases, responsible parties can face personal liability.

Failing to File or Filing Late: Form 1120-S Penalties Add Up Fast

S-Corporations must file Form 1120-S annually, and the deadline matters. For most S-Corps operating on a calendar year, the return is due March 15th (or the next business day if that falls on a weekend).

The penalty for filing late is $220 per shareholder per month (as of 2024), with a maximum of 12 months. For a single-shareholder S-Corp, that’s up to $2,640 in penalties for a late return—before any tax or interest is calculated. For an S-Corp with five shareholders, the maximum penalty reaches $13,200.

I regularly work with clients who didn’t realize their S-Corp required a separate return from their personal taxes, or who assumed an extension gave them extra time they didn’t actually have. These penalties can be abated in some circumstances, particularly for first-time filers or those with reasonable cause, but the process requires knowing how to navigate IRS procedures effectively.

Mixing Personal and Business Expenses: The Audit Invitation

One of the most common mistakes I see—and one of the easiest ways to trigger an audit—is treating the S-Corp’s bank account like a personal checking account. Using company funds for personal expenses, failing to document business purchases, or running personal charges through the business credit card creates problems on multiple levels.

First, it makes your books unreliable. When your records don’t clearly distinguish business from personal spending, you can’t accurately calculate deductions, and neither can the IRS examiner reviewing your return. Second, personal expenses paid by the company may be treated as constructive distributions to you—or worse, as unreported income. Third, sloppy record-keeping suggests to examiners that there may be more serious problems worth investigating.

The solution is simple in concept: maintain separate accounts, document everything, and treat your S-Corp as the separate legal entity it is. Implementation takes discipline, but it’s far less expensive than defending an audit.

Improper Shareholder Loan Documentation

S-Corp shareholders often need to move money between themselves and the company. When handled correctly, shareholder loans are a legitimate tool. When handled poorly, they become audit triggers.

The IRS looks for loans that lack proper documentation—no promissory note, no stated interest rate, no repayment schedule. Without these elements, the agency may recharacterize the “loan” as a distribution or compensation, with corresponding tax consequences.

Legitimate shareholder loans should have written loan agreements with specific terms, reasonable interest rates (the IRS publishes applicable federal rates monthly), actual repayment activity following the stated schedule, and proper recording on the company’s books.

If you’ve been moving money back and forth without documentation, it’s worth getting your records in order before the IRS asks questions.

Distributions Exceeding Basis: An Expensive Mistake

Your basis in an S-Corp represents your investment in the company—your initial capital contribution plus your share of income, minus distributions and your share of losses. This number matters because distributions exceeding your basis are taxable as capital gains.

Many S-Corp owners don’t track basis carefully, particularly in profitable years when they’re taking significant distributions. They assume that because the company has cash, they can take it out tax-free. That’s only true up to your basis.

The fix requires maintaining accurate basis calculations year over year. When I work with new clients, reconstructing basis from years of incomplete records is often one of the first tasks—and it’s far easier to track properly from the start than to recreate later.

Failing to Meet S-Corp Eligibility Requirements

S-Corp status comes with strict eligibility requirements. Violations can terminate your S election—sometimes without you realizing it until the IRS informs you that your company has been operating as a C-Corp for years.

The requirements include having no more than 100 shareholders (though certain family members can be treated as a single shareholder), all shareholders must be U.S. citizens or resident aliens (no foreign shareholders, no corporate shareholders with limited exceptions), the company can have only one class of stock, and certain business types—including financial institutions and insurance companies—don’t qualify.

The second-class-of-stock issue trips up more business owners than you’d expect. If shareholder agreements give different shareholders different distribution rights, you may have inadvertently created a second class of stock, terminating your S election.

Late or Incorrect S-Corp Election (Form 2553 Problems)

To elect S-Corp status, you file Form 2553 with the IRS. The deadline is no later than two months and 15 days after the beginning of the tax year you want the election to take effect. Miss this deadline, and you may be stuck as a C-Corp for the year—or longer.

The IRS does offer relief for late elections in certain circumstances. Revenue Procedure 2013-30 provides a path for companies that intended to elect S status but failed to file on time. However, the relief provisions have specific requirements, and the process requires understanding how to present your case effectively.

I’ve helped numerous clients obtain late election relief, but the process is significantly easier when you catch the problem early rather than years after the fact.

California-Specific S-Corp Issues

Operating an S-Corp in California—or doing business in the state—creates additional compliance requirements that out-of-state businesses often overlook.

California imposes a 1.5% tax on S-Corp net income, with a minimum franchise tax of $800 annually regardless of income. This catches new business owners off guard: even if your S-Corp loses money, you owe California $800.

The state also requires its own S-Corp election. Federal S status doesn’t automatically apply at the state level. Filing Form 100S (California S Corporation Franchise or Income Tax Return) without properly electing S status in California creates a mismatch that draws scrutiny from the Franchise Tax Board (FTB).

For multi-state S-Corps, California’s sourcing rules for business income add another layer of complexity. The FTB is aggressive about asserting that income is California-sourced, and their interpretation often differs from the IRS’s.

Employment Tax Issues: Payroll Compliance Matters

S-Corp employment taxes extend beyond reasonable compensation. Failing to properly withhold and remit payroll taxes, missing quarterly deposit deadlines, or not filing Forms 941 on time all create exposure.

In California, the Employment Development Department (EDD) adds state-level payroll requirements. Unemployment insurance, disability insurance, and personal income tax withholding all have separate rules and deadlines. EDD audits focus heavily on worker classification—whether people you’ve treated as independent contractors should actually be classified as employees.

The Trust Fund Recovery Penalty (TFRP) makes payroll tax problems especially serious. If your S-Corp fails to remit withheld taxes, the IRS can assess the penalty personally against any “responsible person”—which typically includes corporate officers. This isn’t a corporate liability you can walk away from; it follows you personally.

Frequently Asked Questions About S-Corp Audits

How likely is my S-Corp to be audited?

Overall audit rates have declined in recent years due to IRS budget constraints, but S-Corps still face higher scrutiny than individual returns. The audit rate varies significantly based on income level—S-Corps with higher revenues face substantially higher audit probabilities. More importantly, certain issues (like the reasonable compensation problem discussed above) attract examiner attention regardless of overall statistics.

What triggers an S-Corp audit?

Common triggers include officer compensation that appears too low relative to distributions, large deductions relative to income, inconsistencies between the S-Corp return and shareholders’ personal returns, prior audit history, and random selection. The IRS also uses data analytics to identify returns that don’t match expected patterns for similar businesses.

What should I do if my S-Corp receives an audit notice?

Don’t panic, but don’t ignore it either. Read the notice carefully to understand exactly what the IRS is requesting and the deadline for response. Gather the relevant documentation. Most importantly, consider getting professional representation before responding—what you say (and don’t say) in the early stages of an audit significantly affects the outcome.

Can I represent myself in an IRS audit?

You can, but there are significant risks. IRS examiners are trained to ask questions that may seem routine but can open new lines of inquiry. Saying the wrong thing—or providing more documentation than requested—can expand an audit’s scope. Professional representation also creates a buffer; the examiner can’t directly question you without going through your representative.

How far back can the IRS audit my S-Corp?

Generally, the IRS has three years from the filing date to audit a return. However, this extends to six years if gross income is understated by more than 25%, and there’s no time limit if fraud is involved or if a return was never filed. For S-Corps, the statute generally runs from when the Form 1120-S was filed.

What records should my S-Corp maintain?

Keep everything related to income, expenses, and basis calculations for at least seven years. This includes bank statements, receipts, invoices, cancelled checks, payroll records, corporate minutes, shareholder agreements, and documentation supporting any significant transactions. Electronic records are acceptable, but make sure they’re backed up and accessible.

How do I determine reasonable compensation for myself?

Research what comparable positions pay in your industry and geographic area. Resources include Bureau of Labor Statistics data, industry salary surveys, and job postings for similar roles. Document your methodology. Some business owners obtain formal compensation studies, which can provide strong audit protection—though this is more common for larger S-Corps.

Can I change my S-Corp’s reasonable salary mid-year?

Yes, but document the business reason. If company performance changed significantly or your role evolved, adjusting compensation is appropriate. What raises flags is setting compensation artificially low for most of the year and then taking large distributions.

How Mike Habib, EA Can Help With Your S-Corp Tax Issues

When S-Corp tax problems arise, having the right representation matters. My practice focuses on helping business owners navigate IRS and state tax authority disputes, and S-Corp issues are a significant part of that work.

Experience That Translates

Before establishing my tax practice, I served as Controller at Xerox Corporation and Director of Finance at AEG. That corporate finance background gives me perspective that many tax practitioners lack—I understand how businesses actually operate, not just how they’re supposed to look on paper. When I’m helping you structure reasonable compensation or defend your deductions, I bring that operational understanding to the table.

Flat Fee Engagements for Cost Certainty

Many clients come to me after receiving quotes from large firms with hourly rates of $850 to $1,500 or more—with no clear estimate of total cost. That uncertainty makes it difficult to make informed decisions about how to handle your tax situation.

I offer flat fee engagements for most S-Corp tax matters. You know what you’re paying upfront, which allows you to evaluate whether representation makes economic sense for your situation. No surprises, no bills that grow beyond what you expected.

Direct Access, Not Junior Staff

At large firms, you often pay partner rates but work primarily with junior associates learning on your case. When you engage my practice, you work directly with me. Your calls go to me. Your questions are answered by me. The person negotiating with the IRS on your behalf is the same person who understands the full picture of your situation.

Nationwide and International Representation

As an Enrolled Agent, I’m licensed to practice before the IRS regardless of where you’re located. Whether your S-Corp is based in California, you operate in multiple states, or you’re an American running a business from overseas, I can represent you. For California-specific matters—FTB, EDD, CDTFA—my Whittier location puts me well-positioned to handle state agency issues effectively.

Comprehensive S-Corp Services

My S-Corp practice covers IRS audit representation and examination defense, reasonable compensation analysis and documentation, late S-Corp election relief (Form 2553 issues), employment tax disputes and Trust Fund Recovery Penalty defense, California FTB audit representation, EDD worker classification audits, multi-state S-Corp compliance, basis calculation and reconstruction, and back tax filing and compliance for delinquent S-Corps.

Take Action Before Problems Escalate

S-Corp tax problems rarely improve with time. Late filing penalties accumulate monthly. Interest on unpaid taxes compounds daily. The longer reasonable compensation issues go unaddressed, the more years of exposure you create.

If you’re facing an IRS audit, have received notices about your S-Corp, or realize you may have made mistakes in previous years, now is the time to address them. Getting proper advice before responding to the IRS can significantly affect your outcome.

Even if you’re not currently facing problems, a review of your S-Corp’s tax structure and compliance can identify issues before they become expensive—and give you confidence that you’re handling things correctly.

Contact Mike Habib, EA to discuss your S-Corp situation. Initial consultations are designed to help you understand your options and make informed decisions about how to proceed. Flat fee quotes are available for most engagements, so you’ll know the cost before committing.

Based in Whittier, Los Angeles County, California, serving S-Corp owners nationwide and Americans living overseas.

Disclaimer: This article provides general information about S-Corp tax issues and is not intended as specific tax or legal advice for your situation. Tax laws change frequently, and individual circumstances vary significantly. Consult with a qualified tax professional before making decisions about your S-Corporation.