The Tax Club Report

The Government Accountability Office recently released a report recommending Congress and the IRS to address long-standing problems with S corporation tax compliance.

S corporations have been around since the 1980s and are considered the most popular entity choice for closely-held businesses. It’s easy to understand why this entity has gained so much popularity since its conception. Aside from providing shareholders with the same liability protection afforded to the shareholders of C corporations, S corporations allow the income, deductions and tax credits to flow through to shareholders, regardless of whether distributions are made. Thus, income is taxed at the shareholder level and not at the corporate level. Also, income from the S corporation is not subject to employment taxes and certain corporate penalty taxes do not apply to this hybrid entity.

According to data provided by the IRS, about 68 percent of S corporation returns filed misreported at least one item. Deducting ineligible expenses was determined to be the most frequent error on the returns. There were also a lot of mistakes found in the calculation of the basis of shareholders when claiming losses that flowed through to their personal returns. The amount of losses that a shareholder can claim on his tax return is limited to his basis in the S corporation. Apparently, tracking basis remains to be one of the biggest challenges for shareholders.

In addition, it appears that a large number of S corporations failed to pay adequate wages to shareholders for the services that they render to the company. A reasonable compensation is required to be paid to shareholders who are deemed employees because of the work that they perform for the corporation. Not doing so would lead to the underpayment of employment taxes and the IRS will re-characterize the profits and levy interest and penalty for non-compliance. This is considered a serious issue by the GAO, who announced that the net shareholder compensation underreporting equaled roughly $23.6 billion!

The IRS has not released any clear guidance on what tantamount to reasonable compensation and this is seen to hinder compliance and enforcement. Studies show that the average S corporation allocates about 41.5% of the profit to shareholders in the form of salaries and the remaining 58.5% in the form of K-1 distributions. Among tax professionals, however, the following practices have been resorted to when determining how much is reasonable:

• Using industry averages and surveys
• Finding salary data online at various websites that offer salary calculators
• Determining how much comparable employees are paid by comparable corporations

 The IRS generally agreed with the Government Accountability Office’s recommendations and that indicates more audits will be performed on S corporations in the near future. Now that the IRS is beginning to take a harder look at S-corporations, both the shareholders and their tax professionals should carefully evaluate if the deductions taken on the tax return could withstand intense scrutiny, determine if the salary paid to the shareholder/employee is reasonable, re-calculate the basis of the shareholders and be vigilant in maintaining good business records.

Because the S corporation is such a popular strategy for our clients, we will be keeping a close eye on these issues.  We here at the Tax Club are committed to assisting you with any or all of your tax issues. Please contact us for a free tax consultation at (866)840-1829.

Tags: Tax Compliance, tax returns, the tax club

This entry was posted on Monday, February 1st, 2010 at 3:06 pm and is filed under Uncategorized. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.