The IRS tends to keep an eye on unreasonable compensation in three distinct situations. The first involves a C-corporation that overpays their shareholder-employees in order to increase its deduction for business expenses. The second involves S-corporations who underpay shareholder-employees to reduce payroll tax obligations, and shareholder FICA taxes. The third occurs in non-profit entities where key employees may abuse their authority to increase their own pay.
The first two situations involve cases where a shareholder-employee is going to receive income one way or the other, but may reduce their overall tax liability by characterizing the income as salary or dividends. For example, a C-corporation can deduct salaries paid to its employees as an ordinary business expense, but it cannot deduct dividends paid to shareholders.
This creates a potential tax planning opportunity, or a potential tax evasion opportunity, depending on your perspective. The IRS is particularly suspicious of closely-held corporations where the executives are also the major shareholders. If compensation is unreasonable, the IRS may want to recharacterize it as a dividend, resulting in an increase of tax liability, and possibly including accuracy-related penalties.