Why Average Isn't Enough: The Most Common Mistakes I Find in S-Corp Tax Returns

When Your CPA’s Mistakes Cost You Thousands – Why Average Isn’t Enough for Your S-Corp

Every year, like clockwork, I review tax returns that make me shake my head. And I don’t mean mistakes from business owners trying to do their own taxes—I’m talking about returns prepared by CPAs. Professionals who are supposed to know better.

It happens EVERY year.

I’ll be deep in a tax return review, and then suddenly, BAM—there it is. A blatant mistake that could be costing the business owner thousands. And I always think the same thing: Why are CPAs still making these mistakes?

The truth is, all CPAs have access to the same level of education. There is no secret handbook that only some of us get. There is no information gap. So when I see these errors over and over again, there are only two explanations: either they don’t have the time, the desire, or both to learn more about this for the benefit of their clients. And that, to me, is unacceptable.

So today, I’m breaking down the most common errors I find in S-Corp tax returns—errors that might be lurking in your return right now.

1. The Reasonable Compensation Trap

If you’re an S-Corp owner and you’re not paying yourself reasonable compensation, let me put it bluntly: You’re asking for IRS trouble.

One of the main benefits of an S-Corp is avoiding self-employment tax on distributions. But there’s a catch—you must pay yourself a reasonable salary first. And yet, I constantly see S-Corp owners with salaries that are way too low. I’m talking about a business making six figures with the owner reporting a $5,000 salary.

Look, the IRS is not stupid. They know when someone is trying to dodge payroll taxes. If you get audited and they decide your salary isn’t reasonable, they’ll reclassify distributions as wages, hit you with payroll tax penalties, and make you regret every dollar you tried to save.

Now, let’s clear up a huge misconception: There is absolutely, positively no set percentage allocation for salary vs. distributions. None. Zero. Nada. If someone tells you to follow a simple “50/50” or “60/40” rule, run. That’s not how reasonable compensation works. If your CPA tells you this, run the other way.

And don’t even get me started on the so-called “payroll matrix” floating around on YouTube. I’ve seen a certain influencer confidently promoting a chart that supposedly tells you how much to pay yourself based on revenue. Listen, I will bet you anything—an IRS auditor will not accept this. Why? Because reasonable compensation is based on industry standards, job duties, experience, location, and other factors. It’s not some cookie-cutter formula.

The Consequences of a Low Salary

Underpaying yourself isn’t just an IRS problem—it can also have serious state-level consequences:

• Federal Payroll Tax Issues – The IRS expects payroll taxes (Social Security, Medicare, FUTA) to be withheld and reported correctly. If they determine your salary is too low, they will reclassify your distributions as wages, and you’ll owe back payroll taxes plus penalties and interest.

• State Payroll Tax Audits – Many states have employment tax agencies that conduct their own audits, and they don’t play around. If your salary is unreasonably low, your state could slap you with penalties for unpaid state payroll taxes, unemployment insurance, and workers’ compensation fees.

• Unemployment Benefits & Workers’ Comp – Paying yourself too little (or not at all) means you’re contributing little or nothing to unemployment insurance. If you ever need to file for unemployment, you might not qualify because you haven’t paid enough into the system. And if you or an employee gets injured, underreported payroll could cause workers’ compensation issues.

• Retirement Contributions & Social Security Benefits – Your Social Security and Medicare benefits are calculated based on reported wages. If you’re underpaying yourself, you’re also shortchanging your future benefits. And if you want to contribute to a Solo 401(k) or SEP IRA, your ability to save for retirement is limited by your low salary.

  
  

So please, please, please make sure you’re paying yourself a fair market salary based on your industry, experience, and role in the business. The IRS looks at comparable salaries, so don’t lowball yourself into an audit.

2. Misclassifying Distributions as Expenses

This one is a sneaky mistake that can get your return flagged fast. I’ve seen CPAs book S-Corp distributions as expenses instead of equity draws. This is a problem because expenses lower taxable income—but distributions don’t.

What happens if you get this wrong?You’re artificially reducing your taxable profit. And if the IRS catches it, they’ll not only correct it but also hit you with penalties and interest for underreporting income.

Distributions should be recorded as equity draws, not as expenses. If you see "owner draw" under expenses in your books, fix it ASAP.

3. Deducting Personal Expenses Through the Business

I know, I know—everyone wants to write off personal expenses. And I’m all for maximizing tax deductions. But there’s a right way and a wrong way.

I’ve seen S-Corp returns with expenses that clearly shouldn’t be there:

• Grocery bills coded as “Meals & Entertainment”

• Personal vacations magically turning into “Business Travel”

• Luxury watches claimed as “Office Supplies” (yes, really)

  
  

When the IRS audits you (and they will if they see enough red flags), they’ll disallow these deductions, recalculate your tax bill, and throw on penalties and interest.

Now, before you panic, there is a legitimate way to reimburse yourself for certain business-related expenses—it’s called an Accountable Plan. This is a structured way for your business to reimburse you for out-of-pocket expenses tax-free. If you’re running personal expenses through your business without one, you’re setting yourself up for a tax nightmare.

Keep business and personal expenses separate. If you want to make something deductible, make sure it’s legitimately tied to your business. And if you’re personally paying for things like home office expenses or mileage, look into setting up an Accountable Plan (this is a topic for another day, but trust me, it’s worth knowing about).

Final Thoughts: Is Your CPA Actually Helping You?

These mistakes aren’t just theoretical. I see them every year. And every year, I have to break the news to business owners that their tax return has errors that could cost them thousands—or trigger an audit.

The worst part? These mistakes aren’t coming from DIY tax software or inexperienced business owners. They’re coming from CPAs.

And remember—all CPAs have access to the same knowledge. If your CPA isn’t catching these mistakes, it’s not because they don’t have access to the right information. It’s because they either don’t have the time, the desire, or both to stay up to date for the benefit of their clients.

That’s why I do what I do. Because average isn’t enough.

Ensure your S-Corp tax strategy is working for you—not against you. Apply today for a Value Conversation, where we’ll determine if tax planning can help you keep more of what you earn.