| |
 |
Newsletter - Fall 2007
Study Focuses on S Corp Compliance
|
|
In July 2005, the IRS launched a study involving 5,000 randomly selected S corporation returns from tax years 2003 and 2004. The purpose of the study, carried out under the National Research Program (NRP), was to assess the reporting compliance of S corporations.
The results of the current NRP study
will be used to more accurately assess the
extent to which income, deductions and credits
from S corporations are properly reported on
Form 1120S and the shareholders' personal
tax returns. When completed, the IRS expects that
this research will help them select and audit S
corporation returns with greater compliance risk.
By the late 1990's, S corporations had
become the most common corporate entity.
In 2004, tax returns filed by S corporations
accounted for more than 63% of all corporate
returns filed. The current S corporation study,
which is continuing through 2007, represents
the first time the IRS has conducted a reporting
compliance study across tax years.
Because of the limited size of the NRP
study, most taxpayers and practitioners have not
been directly affected. However, both taxpayers
and practitioners will be impacted in the next few
years by the results of the study. While the IRS
has not officially announced the issues or areas
it is particularly interested in, an expected area
of continued scrutiny relates to compensation paid
to shareholders who perform services.
Compensation is subject to payroll taxes,
while pass-through income is not. The increased
pass-through income resulting from a lower
compensation deduction increases each shareholder's
stock basis, thereby permitting distributions without additional income or employment
taxes. Therefore, it can be to an S corporation
shareholder's advantage (but increasingly risky
from a tax perspective as discussed below) to
reduce or eliminate salary and withdraw funds
from the corporation through distributions instead.
Doing so will reduce or eliminate both employee
and employer FICA taxes and reduce or eliminate
unemployment taxes as well.
The IRS is well aware of these strategies
for reducing or eliminating S corporation
compensation, particularly the strategy for
minimizing salaries to reduce payroll taxes.
Reportedly, it has developed methods for
identifying S corporation returns for audit
that appear to have relatively small salaries in
relation to corporate profits. The IRS has made
it increasingly clear that distributions to an
actively employed S corporation shareholder will
be recharacterized as wages subject to payroll
taxes if the distributions are actually disguised
compensation.
In general, taxpayers will not prevail when
the compensation is unreasonably low. While
the reasonableness determination is based on
the facts and circumstances, in many situations
compensation can be set at the low end of a
wide salary range that is both reasonable and
supportable. The better the documentation why
the amounts characterized as wages are reasonable
and appropriate, the more likely that the
characterization will withstand IRS attack.
|
|
|
|
