Part 7: S-Corp Audit Risks & Red Flags — What the IRS Looks For in 2025

🚨 S-Corp Audit Risks & Red Flags — What the IRS Looks For in 2025

S-Corporations offer powerful tax advantages, but they also attract IRS attention when owners misuse salary rules, deductions, or shareholder distributions.
In this Part 7 guide, we outline the most common S-Corp audit triggers, how the IRS evaluates “reasonable compensation,” and which practices often result in penalties or reclassification of distributions as wages.

1️⃣ Reasonable Compensation Red Flags

The IRS consistently states that unreasonably low salaries are the #1 audit trigger for S-Corporations.

❗ Red Flags

• Owner takes $0 salary while receiving large distributions
• Salary below industry standards without documentation
• No written job duties, hours, or role descriptions
• Year-end lump-sum payroll instead of scheduled payroll

The IRS often uses comparable wage data, industry salary ranges, and third-party payroll surveys to determine whether compensation is adequate.

2️⃣ Distribution vs Wage Misclassification

When distributions greatly exceed salary, the IRS may reclassify distributions as wages, creating:

• Back payroll taxes
• Penalties for late payroll deposits
• Accuracy-related penalties
• Interest on unpaid liabilities

A balanced structure (salary + distributions) supported by documentation significantly reduces audit risk.

3️⃣ Shareholder Loans & Basis Issues

Improper shareholder loans can create audit exposure when used to:

• Artificially create basis
• Avoid payroll taxes
• Replace proper wage payments

⚠️ Common IRS Concerns

• No loan agreements or repayment schedules
• Loans disguised as distributions
• Loans that never get repaid
• Unclear distinction between capital contributions and loans

4️⃣ Aggressive Deduction Patterns

The IRS targets S-Corps with unusually high deductions relative to income.

🚩 Common High-Risk Areas

• Vehicle expenses without logs
• Travel mixed with personal trips
• Excessive home-office reimbursements
• Unsubstantiated contractor payments
• Large Section 179 or equipment deductions inconsistent with business type

An accountable plan is one of the best ways to stay compliant and defend expense reimbursements.

5️⃣ Payroll & Compliance Failures

S-Corp owners often underestimate how seriously the IRS views payroll compliance.

• Late or missing payroll tax deposits
• Incorrect W-2 or W-3 filings
• No quarterly 941 filings
• Misclassified contractors who should be employees

Even if total payroll seems small, compliance failure increases audit likelihood significantly.

6️⃣ High-Risk Industry Profiles

Some industries face higher audit rates due to inconsistent income patterns or common reporting mistakes.

• Real estate agents & brokers
• Consultants & freelancers
• Creative professionals (design, media, photography)
• Construction & trades
• E-commerce & online sellers

These industries often involve mixed-use assets, travel deductions, or inconsistent payroll.

7️⃣ EA Audit-Prevention Checklist

• Document reasonable salary every year
• Run payroll regularly (monthly or quarterly)
• Use an accountable plan for reimbursements
• Maintain mileage logs and receipts
• Prepare accurate shareholder loan documentation
• Ensure W-2, 941, and 940 filings are complete
• Keep minutes and shareholder records updated

8️⃣ Related EA Tax Guide Articles

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