Federal Fraud Enforcement
What Is the False Claims Act?
A complete guide to the federal False Claims Act — how it works, who enforces it, what the penalties are, and why it matters for businesses that received ERC credits or PPP loans.
How you pay yourself as a business owner depends entirely on your entity structure — and getting it wrong means either overpaying self-employment tax or triggering an IRS audit for underpaying payroll tax.
The short version: sole proprietors and default LLCs pay SE tax on all net income. S-corp owners split compensation between a W-2 salary (subject to FICA) and distributions (not subject to FICA) — the split saves real money, but the salary must be defensibly “reasonable.” C-corp owners take a W-2 salary and, separately, qualified dividends after the corporate-level tax. Each structure has different rules, different tax costs, and different audit risks.
What Your Business Structure Means for Your Paycheck
The entity you operate under determines the legal mechanism for paying yourself — and, more importantly, which dollars are subject to self-employment tax (15.3%) versus ordinary income tax only.
Most business owners understand that they will owe federal income tax on business profits. What surprises many is the self-employment tax layer — the 15.3% that replaces the FICA payroll taxes that W-2 employees and their employers split. As a business owner, there is no employer to split it with. You pay both sides.
The entity structure determines how much of your income is exposed to that 15.3%. That is the whole game. The strategies below — S-corp election, accountable plans, reasonable salary structuring — are all variations on the same goal: identifying which dollars are legally and defensibly exempt from the employment tax base.
| Structure | How You “Pay Yourself” | SE / FICA Tax Exposure | Administrative Cost |
|---|---|---|---|
| Sole Proprietorship | Draw from account; no formality required | All net profit (Schedule C) subject to SE tax | Lowest — no payroll required |
| Single-Member LLC (default) | Owner’s draw — same as sole prop (disregarded entity) | All net profit subject to SE tax | Low — same as sole prop |
| LLC Taxed as S-Corp | W-2 salary + distributions above salary | Salary only; distributions exempt from FICA | Moderate — payroll required |
| S-Corporation | W-2 salary + distributions above salary | Salary only; distributions exempt from FICA | Moderate — payroll required |
| C-Corporation | W-2 salary + qualified dividends after corp tax | W-2 salary subject to FICA; dividends taxed separately at 15–20% | Highest — separate corp return, payroll |
Sole Proprietor and Default LLC: The Self-Employment Tax Problem
If you operate as a sole proprietor or a single-member LLC taxed as a disregarded entity, every dollar of net profit is subject to self-employment tax — 15.3% on the first $176,100 of net earnings in 2026, and 2.9% (Medicare only) on everything above that.
You pay yourself by simply transferring money from the business account to your personal account. There is no W-2, no payroll process, no formal distribution. The IRS does not require any of that. The tax bill arrives when you file your return — your Schedule C income flows through to Form 1040, you pay income tax on it at your marginal rate, and then you pay self-employment tax on top of that via Schedule SE.
The deduction for half of SE tax (IRC § 164(f)) provides a modest offset — you can deduct 50% of the SE tax paid as an above-the-line deduction. But the bottom line is that operating as a sole prop or default LLC when your net profit is significant means paying the full employer + employee share of employment taxes. On $150,000 of net profit, that is roughly $19,500 in SE tax alone, in addition to federal income tax.
There is nothing wrong with this structure at lower income levels. The overhead of payroll, S-corp formalities, and annual filings has a real cost. But once your net profit consistently exceeds approximately $40,000–$50,000 per year, the math starts to favor S-corp election. Below that threshold, the administrative cost of running an S-corp typically exceeds the tax savings.
LLC Taxed as an S-Corp: The Salary + Distribution Split
The S-corp compensation strategy splits your business income into two buckets: a W-2 salary (subject to FICA) and profit distributions above the salary (not subject to FICA). The distributions are taxed as ordinary income on your personal return — they just avoid the 15.3% employment tax layer.
An LLC can elect S-corp tax treatment by filing Form 2553 with the IRS. If you missed the deadline, Rev. Proc. 2013-30 provides a procedure for a late S-corp election that the IRS routinely grants. Once elected, the LLC is treated as an S-corporation for federal tax purposes, with the owner operating as both a W-2 employee and the equity holder.
How the math works
The IRS requires you to pay yourself a “reasonable salary” as a W-2 employee for services you render to the company. That salary is subject to FICA — 7.65% employee side, 7.65% employer side, totaling 15.3%. Profit distributions beyond the salary are not subject to FICA. They are still ordinary income to you as a pass-through item on the K-1, but they skip the employment tax.
Example — $200,000 Net Income
S-corp election: $80,000 reasonable salary → FICA cost $12,240 (employer + employee combined). $120,000 distribution → no FICA. Total employment tax: $12,240.
No election (sole prop / default LLC): $200,000 subject to SE tax. First $176,100 at 15.3% = $26,943. Remaining $23,900 at 2.9% = $693. Total SE tax: ~$27,636.
Approximate annual savings from S-corp election: ~$15,400 on the same $200K of income — before considering the cost of payroll services (typically $1,200–$2,400/year).
The 20% QBI deduction under IRC § 199A — extended by the One Big Beautiful Bill Act (“OBBBA”) — applies to S-corp pass-through income as well, making the salary/distribution optimization more significant going forward. The QBI deduction is calculated on qualified business income, which is the pass-through profit net of the W-2 salary. Lower taxable wages and higher distributions can sometimes increase the § 199A benefit, depending on your income level and the applicable wage limitations. This is a calculation worth running with specific numbers rather than assuming.
The Reasonable Compensation Standard (And the Watson Problem)
The whole S-corp strategy turns on one question: what is a “reasonable” salary? The IRS can reclassify distributions as wages if the salary you pay yourself is unreasonably low — triggering back FICA taxes, penalties, and interest.
The obligation to pay reasonable compensation is grounded in IRC § 3111, which imposes employment taxes on wages. Rev. Rul. 74-44 established that an S-corporation’s failure to pay a working shareholder reasonable compensation may result in the IRS treating distributions as disguised wages. The relevant factors — drawn from that ruling and subsequent case law — include:
- The nature and extent of the shareholder-employee’s services
- Time devoted to those services
- The company’s revenues and profits
- What comparable businesses pay for similar services in the same industry
- Whether the distribution is proportionate to ownership (suggesting it reflects profit, not labor)
The most cited case is Watson v. Commissioner, 668 F.3d 1008 (8th Cir. 2012). David Watson, a CPA, took a $24,000 annual salary through his S-corp while distributing over $200,000 to himself. The IRS successfully argued that the bulk of the distributions were disguised wages. The Eighth Circuit affirmed. The court’s analysis was straightforward: Watson performed the services that generated the revenue, those services had market value well above $24,000, and the structure was a transparent attempt to avoid employment taxes.
Watson is the reason a zero-salary S-corp is an automatic audit risk. The IRS has a specific FICA Tax Compliance Project targeting S-corps with significant revenue but minimal or no W-2 wages to shareholders. If your S-corp shows $300,000 in profit and $0 in officer compensation, expect scrutiny.
How to set a defensible reasonable salary
The practical approach is to pay yourself the higher of: (1) what you would pay an outside hire to perform the same services, or (2) an industry-benchmarked salary for your role and geography. The Bureau of Labor Statistics publishes occupational employment data by industry and geography. Compensation databases like the Economic Research Institute or RCReports are routinely used by tax professionals to document the analysis.
Safe Harbor Approach
Document the analysis in writing every year. Pull the comparable compensation data, note the factors relevant to your situation (hours worked, company revenue, comparable market rates), and attach it to your S-corp’s records. If the IRS audits, you have a contemporaneous record of how you arrived at the salary — not a post-hoc justification.
If your salary looks low relative to distributions, be prepared to defend it with data. “I just set it at $60K” is not documentation. “I pay myself $60K because a comparably sized firm in my market pays a [role] between $55K and $70K, and I also receive the residual profit as a return on my investment in the business” is the beginning of a defensible position.
Accountable Plans: The Tax Break Most S-Corp Owners Are Missing
An accountable plan is a formal policy under Treas. Reg. § 1.62-2 that allows an S-corp to reimburse a shareholder-employee for legitimate business expenses — tax-free to the employee and deductible by the corporation.
Most S-corp owners run legitimate business expenses — home office, vehicle use, cell phone, business meals, professional development — but either (a) deduct them personally on Schedule A (where they are capped or phased out), or (b) just absorb them as personal costs. Neither approach is optimal. Under a properly structured accountable plan, the corporation reimburses you for those expenses, the reimbursements are excluded from your gross income under IRC § 62, and the corporation deducts them.
The accountable plan has three requirements under Treas. Reg. § 1.62-2(c):
- Business connection. The expenses must have a legitimate business purpose.
- Substantiation. You must provide the corporation with documentation — receipts, mileage logs, records — within a reasonable time.
- Return of excess amounts. If the corporation advances more than the documented expenses, the excess must be returned.
If all three requirements are met, the reimbursements are not wages — they do not appear on your W-2, they are not subject to FICA, and they are not taxable income to you. This is genuinely free money if you have legitimate business expenses you are currently paying personally.
The most common application is the home office. Under IRC § 280A, individual deductions for a home office are limited and often phased out. But if your S-corp reimburses you for the business-use portion of your home expenses under an accountable plan, the reimbursement is fully deductible by the corp and excluded from your income. The same logic applies to the business-use percentage of your vehicle, your cell phone, and any equipment you own personally but use for the business.
Setting up an accountable plan is not administratively complex. You need a written plan document, a reimbursement request process, and a practice of submitting receipts and mileage logs. Most S-corp owners skip this entirely. We see it repeatedly — clients paying $8,000–$15,000 per year in personal expenses that could be reimbursed tax-free.
C-Corporation Pay Considerations
A C-corporation owner typically takes compensation as a W-2 salary (deductible by the corp, subject to FICA at the individual level) or as qualified dividends after the corporate-level tax — the “double taxation” structure that often makes C-corps less efficient for owner-operators.
The C-corp structure is primarily attractive for specific situations, not as a default for small business owners. The federal corporate rate is 21% (flat). If you can retain earnings inside the corporation — and you have a use for them there, such as reinvestment in the business, capital expenditures, or building a war chest for an acquisition — the 21% rate may be lower than your personal rate. This differential matters most for high-income business owners where the pass-through income would be taxed at 37% federal plus state.
The “double taxation” problem: C-corp profits are taxed at 21% at the corporate level. When you distribute those profits as dividends, you pay qualified dividend rates at the individual level — currently 15% for most taxpayers, 20% above the threshold (approximately $553K for single filers in 2026), plus the 3.8% Net Investment Income Tax if applicable. On $100,000 of C-corp earnings, you might pay $21,000 in corporate tax, then 18.8% on the $79,000 remaining if distributed — a combined effective rate above 35%.
The W-2 salary alternative avoids the dividend-level tax but triggers FICA. Typically, C-corp owners pay themselves a reasonable market salary (which the corp deducts, reducing corporate taxable income), then leave residual profits in the corp where they compound at the 21% rate. The retained earnings strategy works until there is a liquidating event — a sale, a distribution, or a conversion — at which point the accumulated deferred tax becomes due.
C-corp structure makes a lot more sense for businesses planning a sale where QSBS under IRC § 1202 applies, for venture-backed companies with multiple investors, and for businesses with capital intensity that justifies retention of earnings. It is rarely the right structure for a service-based owner-operator who needs to pull most of the profits out annually.
How to Decide Whether to Elect S-Corp Status
S-corp election is not always the right move. If your net profit is under roughly $40,000–$50,000 per year, the administrative cost of running an S-corp — payroll taxes, payroll services, the additional state filing fees — will likely exceed the FICA savings.
The breakeven analysis is straightforward. If your net profit is $50,000, a reasonable salary might be $40,000 — leaving only $10,000 in distributions. The FICA savings on $10,000 is about $1,530. The cost of payroll services, an S-corp state filing, and potentially a CPA to prepare the additional return often exceeds $1,500–$2,500 per year. You break even at best and possibly lose money on the election.
At $100,000 in net profit, the picture shifts materially. A $60,000 reasonable salary leaves $40,000 in distributions. FICA savings: ~$6,120. Administrative overhead: ~$1,500–$2,500. Net savings: $3,600–$4,600 per year. That is worth the election.
At $200,000 and above, the savings compound quickly. As illustrated in the example above, the annual FICA savings can exceed $15,000. The administrative cost stays roughly flat. S-corp election is almost universally the right call above this income level for active owner-operators.
Common mistakes to avoid after S-corp election
- Paying zero salary. The Watson problem — do not do this. The IRS flags S-corps with significant revenue and zero officer compensation for FICA audits.
- Not setting up an accountable plan. See Section 5 above. This is the most consistently overlooked savings mechanism for S-corp owners.
- Taking distributions when there is no accumulated adjustments account (AAA) balance. Distributions from an S-corp are generally non-taxable return of basis — but only to the extent of the shareholder’s AAA. Distributions in excess of AAA are treated as dividend income, not capital gain or return of basis. This creates a different and sometimes worse tax result than expected.
- Ignoring estimated tax timing. Your salary will have withholding. Your distributions will not. If the distributions are large, you need to increase estimated tax payments or face underpayment penalties.
- Converting when income is too low. As discussed above — confirm the math before filing Form 2553.
How Brotman Law Helps Business Owners Structure Compensation
Business owner compensation planning is a specific subset of business tax strategy — one with real dollars at stake and real audit risk if done wrong.
The work we do typically involves four things. First, analyzing whether S-corp election makes sense for your current income level and projections. Second, if you are already an S-corp, reviewing your reasonable salary position and documenting the analysis against industry benchmarks. Third, reviewing whether an accountable plan is in place and, if not, setting one up. Fourth, integrating all of this into your annual tax planning so the salary/distribution split and estimated payments are optimized throughout the year, not retrofitted at filing.
We work closely with your existing CPA — or we can refer you to one if you need a good one. The tax advisory work is the legal layer: entity structure analysis, opinion-level analysis on reasonable compensation positions, and documentation. The compliance work is your CPA’s domain. The two functions are complementary.
If you have questions about S-corp election, reasonable compensation, or accountable plans, the starting point is a 15-minute call. We will identify the relevant facts, tell you whether there is meaningful savings on the table, and scope what the engagement looks like from there.
Want the broader picture? See our business tax strategy practice or our tax advisory services.
Frequently Asked Questions
False Claims Act
What is the False Claims Act in simple terms?
The False Claims Act is a federal law that makes it illegal to submit a false bill or claim for payment to the U.S. government. If someone knowingly submits a fraudulent claim — for federal contracts, Medicare/Medicaid, ERC credits, PPP loans, or any other federal program — the law requires them to pay back three times what the government lost, plus civil penalties of up to $27,894 per false claim submitted. Private citizens can also sue on the government’s behalf and collect a share of any recovery.
What are the penalties under the False Claims Act?
- FCA penalties include: Mandatory treble damages — three times the government’s actual losses; and.
- Civil penalties of $13,946 to $27,894 per false claim (2024 rates, adjusted annually).
These penalties apply separately to each false claim submitted, so in cases involving multiple quarterly filings or multiple entities, the total penalty exposure can far exceed the actual amount at issue. For a $500,000 ERC claim supported by 28 quarterly filings across four entities, the minimum statutory exposure exceeds $1.8 million.
How is the False Claims Act different from criminal fraud charges?
The False Claims Act is a civil statute — violations result in money judgments, not prison time. But the same conduct that gives rise to FCA civil liability often also supports criminal charges: 18 U.S.C. § 287 (false claims to a federal agency, up to 5 years), 18 U.S.C. § 1001 (false statements, up to 5 years), 18 U.S.C. § 1014 (false statements on loan applications, up to 30 years for financial institution fraud). The DOJ routinely coordinates civil FCA investigations with criminal prosecutors, and civil and criminal cases frequently proceed simultaneously.
Does the False Claims Act apply to ERC credits?
Yes. The government’s position is that each amended Form 941-X claiming the Employee Retention Credit is a “claim for payment” to the United States under the FCA. If the IRS paid an ERC claim that the government believes was fraudulent, the DOJ can bring an FCA civil case seeking treble damages plus per-claim penalties. The COVID-19 Fraud Enforcement Task Force has made ERC fraud a priority enforcement area, and dozens of FCA civil suits and criminal prosecutions have already been filed.
Does the False Claims Act apply to ERC credits?
Yes. The 2009 Fraud Enforcement and Recovery Act expanded the FCA to cover any claim submitted to a contractor, grantee, or other recipient of federal funds — which includes private lenders administering SBA-backed PPP loans. False certifications on PPP loan applications (headcount, payroll amounts, intended use of funds) and PPP forgiveness applications (actual use of funds) can both give rise to FCA civil liability.
What is a qui tam lawsuit?
A qui tam lawsuit is a civil suit filed by a private individual — called a relator or whistleblower — under the FCA on behalf of the United States government. The relator files the complaint under seal (confidentially), and the DOJ investigates before deciding whether to intervene. If the case succeeds, the relator receives 15%–30% of the government’s recovery. In ERC and PPP fraud cases, qui tam relators have included former employees, accountants, competitors, and ERC promoters cooperating with the government.
What is the FCA statute of limitations?
FCA civil claims must be filed within six years of the date of the violation, or three years after the date the government official responsible for acting first knew or reasonably should have known about the violation — whichever is later, but no more than ten years after the violation. For ERC claims filed in 2020 and 2021, the six-year period runs through 2026 and 2027. Given active enforcement activity, ERC and PPP matters are squarely within the enforcement window right now.
What are the defenses to a False Claims Act allegation?
The main FCA defenses are:
- The claim was not actually false — demonstrating genuine eligibility.
- No “knowing” violation — the submission was made in good faith reliance on professional advice.
- The public disclosure bar — the allegations were already publicly known before the relator filed.
- Materiality — the alleged falsehood did not actually affect the government’s payment decision.
- Statute of limitations.
- The first-to-file bar — a related qui tam was already pending when this one was filed. Which defenses are available depends entirely on the specific facts of the case.
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