The IRS fully understands the temptation and actively looks for S corporation owners who reduce funds from Spigot A (also known as compensation) in favor of Spigot B (aka shareholder distributions). In fact, according to a publication for accountants, one of the "hottest audit triggers" is when the IRS detects "insufficient compensation paid to shareholders." Obviously, one of the last things a small business owner wants is to trigger an IRS audit.
The article in the Journal of Accountancy encourages S corporation owners and accountants to take a fresh look at the way shareholder distribution and compensation are handled in order to avoid an audit.
One of the suggested ways is to confirm the percentage of time devoted to the business. After all, the IRS might well compare your reported time devoted to business by corporation officers to similar-sized corporations in your industry. If your compensation numbers are way below average for your industry, a red flag might well go up.
Once the flag is up, your S corporation could be subject to an audit that results in increased payroll taxes owed, as well as penalties and interest on the taxes.
Of course, not all IRS audit findings have to be considered final. An experienced tax attorney can help you appeal the audit and help you navigate the complex appeals process. In that way, you might find favorable resolutions of disputes over significant liabilities.