Artificial intelligence is changing the way businesses operate—and the IRS is no exception.
The IRS has confirmed that it is using artificial intelligence, advanced analytics, and other technology to identify areas of potential tax noncompliance and fraud. For S corporation owners, this development makes one long-standing tax issue more important than ever: Are you paying yourself reasonable compensation?
For years, the IRS has scrutinized S corporation owners who take large distributions from their businesses while paying themselves little—or no—W-2 wages. As the IRS becomes increasingly sophisticated in how it analyzes tax-return data, unusual compensation patterns may become easier for the government to identify.
The IRS Is Increasing Its Use of AI and Data Analytics
The IRS is already using artificial intelligence and advanced analytics in tax administration and compliance work.
In 2026 testimony before Congress, IRS leadership stated that the agency is using AI and advanced analytics to identify high-risk areas of noncompliance and fraud with greater accuracy. The Government Accountability Office has also reported numerous active IRS AI use cases, including applications involving tax compliance, fraud detection, and audit selection.
The IRS's increasing use of technology has also been a topic at the 2026 IRS Nationwide Tax Forums, including sessions addressing technology, compliance, and artificial intelligence.
What does that mean for the average small-business owner? It means taxpayers should not assume that an IRS employee must manually review a return before an unusual pattern can attract attention.
Why S Corporations Are Particularly Important
One of the primary tax advantages of an S corporation is that shareholder distributions generally are not subject to Social Security and Medicare taxes. Wages are.
Consider an S corporation that generates $200,000 of income for its sole shareholder. If the owner pays herself $100,000 in W-2 wages and takes $100,000 in S corporation distributions, the salary is generally subject to applicable payroll taxes. But if the owner instead reports only $20,000 in wages and $180,000 in distributions, the employment-tax result is very different.
This is why the IRS has long required shareholder-employees to receive reasonable compensation for the services they provide to the corporation before taking non-wage distributions.
AI Makes Unusual Compensation Patterns Easier to Identify
The IRS receives an enormous amount of information electronically. For an S corporation and its shareholder, that information can include Form 1120-S, Schedule K-1, Forms W-2, payroll tax returns, and information reported on the shareholder's individual income tax return.
Advanced data analytics potentially make it much easier to identify relationships among these numbers. For example, an S corporation reporting $400,000 of business income, $300,000 of shareholder distributions, and only $35,000 of officer compensation could potentially stand out differently from a comparable business reporting substantial shareholder wages.
Technology also makes it increasingly possible to analyze taxpayers across industries, occupations, income levels, and other characteristics.
Important: The IRS has confirmed that it uses AI and advanced analytics for compliance and enforcement purposes. However, as of this writing, the IRS has not publicly announced a specific AI program that automatically determines reasonable compensation for S corporation shareholders.
Nevertheless, reasonable compensation is the type of issue that can benefit from sophisticated data analysis because much of the relevant information is already reported to the government.
What Does the IRS Consider “Reasonable Compensation”?
There is no IRS rule stating that every S corporation owner must pay herself a particular percentage of profits. Rules of thumb such as a 60/40 salary-to-distribution split are not IRS rules.
Reasonable compensation depends upon the facts and circumstances. According to the IRS, factors that may be considered include:
- Training and experience
- Duties and responsibilities
- Time and effort devoted to the business
- Dividend or distribution history
- Payments to non-shareholder employees
- Timing and manner of bonuses
- What comparable businesses pay for similar services
- Compensation agreements
- The method or formula used to determine compensation
Another particularly important consideration is how the S corporation generates its revenue. If most of the company's revenue is attributable directly to the shareholder's personal services, the reasonable-compensation issue becomes especially significant. This can be especially relevant for professional and service businesses such as consulting firms, accounting practices, medical practices, law firms, real estate businesses, construction companies, and other owner-operated businesses.
“My Accountant Told Me to Pay Myself $50,000” May Not Be Enough
One of the biggest mistakes S corporation owners make is choosing an arbitrary salary. The question should not simply be, “What is the lowest salary I can get away with?” A better question is, “What would my company reasonably have to pay someone else to perform the work I perform?”
Consider an owner who acts as the company's CEO, salesperson, operations manager, and primary revenue producer. If replacing that person would require hiring several employees at a combined cost of $175,000 per year, paying the shareholder a $30,000 salary simply because “that's what we've always done” could be difficult to defend.
Conversely, a business that generates substantial income from employees, equipment, intellectual property, or invested capital may present a very different reasonable-compensation analysis. This is why reasonable compensation should be based on the taxpayer's actual circumstances—not an arbitrary percentage.
What Happens If the IRS Disagrees?
The IRS has the authority to reclassify S corporation distributions or other payments as wages when a shareholder-employee has not received appropriate compensation for services. That can result in additional employment taxes and potentially interest and penalties.
The IRS has successfully challenged unreasonable compensation structures in court. One of the best-known cases is David E. Watson, P.C. v. United States. In that case, an accountant received a $24,000 salary while receiving significantly larger distributions from his S corporation. The courts upheld the government's position regarding the treatment of compensation.
The lesson is simple: Having some W-2 compensation does not automatically mean the compensation is reasonable.
What S Corporation Owners Should Do Now
S corporation owners should not panic because the IRS is using AI. They should document.
If you own an S corporation and actively work in the business, review your compensation annually. Consider what services you actually perform, how many hours you work, how much of the company's revenue is generated by your personal services, what another business would pay someone to perform your job, how your salary compares with your distributions, and whether you can explain how your compensation was determined.
Most importantly: Can you document it?
A reasonable-compensation analysis performed and documented before an IRS examination is considerably more valuable than trying to reconstruct the reasoning several years later.
The Bottom Line
Artificial intelligence does not change the S corporation reasonable-compensation rules. It potentially changes the IRS's ability to identify taxpayers whose returns warrant a closer look.
The IRS has publicly confirmed that it is using AI and advanced analytics to improve compliance and identify higher-risk areas of noncompliance. At the same time, reasonable compensation remains a long-standing enforcement issue for S corporations.
Do not choose your salary based on an arbitrary number. Do not assume that taking some salary automatically satisfies the reasonable-compensation requirement. And do not wait for an IRS notice to determine whether your compensation can be supported.
If you are an S corporation shareholder who works in your business, now is a good time to review your compensation strategy and make sure you have documentation supporting the amount you're paying yourself.
Green Krist, CPA specializes in assisting taxpayers with IRS and North Carolina Department of Revenue issues in the greater Raleigh, North Carolina area.
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