Article Originally Published in the Atlanta Business Chronicle by Markita Jones on March 2, 2012.
The IRS has increased its efforts to audit more tax returns of S corporations.
Given the popularity of the S corporation form of business and the amplified focus on reducing the tax gap, this increased scrutiny is no surprise.
However, if an IRS audit is one of your biggest nightmares (and one that has come to fruition for many S corporations in the past few years), this article will address some primary issues that you should be aware of, including the heightened attention to S corporation compensation practices and shareholder loans. It will also provide some guidance for meeting IRS expectations as you prepare your S corporation for success in the new year.
Reasonable compensation
The issue of reasonable compensation has been a hot topic for some time. The IRS is aware that owner-employees of many S corporations have avoided paying payroll taxes by taking distributions from the corporation instead of paying themselves a “reasonable” wage. By taking tax-free distributions or passing profits through to the shareholder as income rather than paying reasonable wages, shareholders and their company have avoided the employer and employee payroll taxes. The likelihood of an IRS audit is increased when S corporations have relatively low officer salaries and wages in relation to profits, or when they make large distributions with low salaries.
For the S corporation acting in good faith, it is best to avoid these issues and review W-2 wages and distributions to owner-employees made during the year. The IRS will reclassify distributions as salaries if it determines the wages are unreasonably low. Payroll taxes will be assessed on these salaries, along with interest and large penalties for failure to pay.
Determining compensation
In the ongoing debate on reasonable compensation, it is often asked, “Who determines what is ‘reasonable’?” What may be considered reasonable for a company making millions may not be reasonable for a small business or a young corporation, and there is plenty of room for discretion in setting salaries. However, there are obvious pitfalls one can avoid.
A critical look at the financial status of the corporation is an excellent starting point. If most of the gross receipts and profits are associated with the shareholder’s personal services, then most of the profit distribution should be allocated as compensation. In addition to gross receipts, the corporation should also look at comparable salaries in the industry. If most managers in your industry are earning $200,000 a year, it would be unwise to pay yourself only $25,000 and take $175,000 in tax-free distributions. This will almost guarantee scrutiny from the IRS. Other factors to consider are the size and complexities of the business as well as economic conditions. It is not unreasonable for smaller companies to pay lower wages, and many companies have reduced wages in recent years due to the economic downturn. Ultimately, the salaries of all employees should be in line with the work performed. The IRS has experts to determine the market value of services performed and they will put them to work if wages appear unreasonable.
Loans from shareholders
In poor economic times, one advantage of the S corporation is that its losses are passed through to the owners’ personal tax returns to potentially offset other income. However, it is important to remember that the amount of deductible losses is limited to the basis the shareholder has in the corporation.
Many S corporation owners have discovered they have losses but are unable to deduct the losses in the current year because their basis has reached zero.
One solution to this problem is for the shareholder to loan the corporation money, increasing their debt basis in order to enable deduction of the losses in the current year. In its audits of S corporations, however, the IRS is finding a lack of direct economic outlay by the shareholder. Bank loans to the company that are personally guaranteed by the shareholder do not create debt basis, nor do loans from related companies. The loan must be made directly by the shareholder to create debt basis and allow losses to be deducted.
Loans to shareholders
Sometimes a company distributes money to its shareholders and intends to treat it as a loan rather than a distribution. Without proper documentation and facts supporting this treatment, the IRS may make the argument that this payment is actually a distribution. The IRS is taking a closer look at the facts and circumstances surrounding loans to shareholders to determine whether they are in fact bona fide loans. If the shareholder does not repay the loan or there is no clear intention to repay, the IRS will reclassify the loan as distributions or compensation.
Document loans
To avoid problems with the IRS, shareholder loans should be properly documented through interest-bearing promissory notes and recorded in corporate minutes. It is also a good idea to have records showing interest payments on the loan. Lack of proper documentation and failure to prove intent to repay are the biggest reasons the IRS is successful in its challenges.
Being aware of common red flags and trends in IRS examinations can help ensure your company’s policies are in line with IRS guidelines and that proper documentation is maintained. Each company’s tax situation is unique and often complex, so you should always consult with your tax professional for specific guidance.
