S Corps     Are on the IRS Examination    Radar Screen

The IRS has known for years that S corporations are sometimes used to circumvent federal income and employment taxes. Despite this, relatively few S corps and shareholders have been audited in recent years. However, things are changing. The IRS has announced that the number of S corps has "exploded" in the last 20 years and it plans to increase scrutiny of businesses that operate this way. In other words, S corps and their shareholders are no longer flying beneath the IRS radar.

S Corps are Growing More Popular

S corporations are incorporated legal entities that “pass through” their income, deduction, and tax credit items to shareholders — generally individuals and trusts. Typically, S corps themselves don’t owe any federal taxes other than employment taxes on wages paid to their employees (including shareholder-employees).      Here are some statistics about the increasing popularity of S corps:      Since the mid-1980s, the number of S corps has risen rapidly, growing from about 725,000 in 1985 to about 3.15 million in 2002 (the latest year for which IRS data is available). By a good margin, S corps are now the most common type of corporate entity.       In 2002, S corp returns accounted for 59 percent of all corporate returns filed. Two million S corps reported net income of about $248 billion and 1.2 million S corps reported net losses of about $63 billion.     Rapid growth combined with the fact that S corps can be used for tax-saving purposes (both legal and otherwise) explains why the IRS has made them an audit target.     “The use of S corporations has exploded,” says IRS Commissioner Mark W. Everson. “The IRS needs a better understanding of what this means for tax compliance. This research is critical for achieving our strategic goal of ensuring that corporations and high-income individuals are paying their fair share.”

Part of the initiative involves looking into how well S corps and their shareholders comply with federal tax laws. This "study" is under the auspices of the National Research Program, which gathers information to enable IRS personnel to do a better job selecting and auditing taxpayers who underpay federal taxes. The new initiative will examine 5,000 randomly selected S corp returns.

The tax agency is using an approach designed to reach statistically valid conclusions regarding tax compliance behavior. The results of the study will be used to more accurately gauge the extent to which income, deductions and credits from S corps are properly reported on returns filed by the corporations and their shareholders. When completed, the research will help the IRS choose and audit other S corp returns. Although IRS officials don’t come right out and say it, it is likely we'll see more audits of S corps and their shareholders, as well as more intensive and focused examinations.

As you may know, S corp shareholders receive Schedule K-1s reporting their share of S corp tax items. The information should then be reflected on each shareholder’s tax return. The IRS recently redesigned Schedule K-1 and the updated form makes it easier for the tax agency to see if shareholders are properly reporting tax items passed though from S corps.

One popular tax saving strategy is for S corps to pay shareholders a relatively modest corporate salary in order to reduce Social Security and Medicare taxes. How it works: If a business is run as an S corporation, the shareholders are generally also employees of the business. As such, the corporation pays them a salary.

However, the first $94,200 of 2006 salary is subject to a 15.3 percent federal employment tax rate. Of that, 12.4 percent is for Social Security tax and 2.9 percent is for Medicare tax. Half of these employment taxes are withheld from salary checks. The other half is paid directly to the government by the S corporation in its role as your employer. You must, of course, pay income tax at your personal level on salary received from the corporation.

In addition to their minimal salaries, S corp employee-shareholders often take cash distributions, which of course, do not involve Medicare or Security Social taxes. 

In many audits and court cases involving S corps, shareholders have been found to take ridiculously low salaries for the positions and industries they are in. To prevail, shareholders must be prepared to show that salary levels are reasonable for the work performed. If they are way too small, the IRS could reclassify purported S corp distributions as disguised salary payments and then hit the company with bills for back employment taxes, interest, and penalties.

Here are some other S corp issues that we can expect to see brought up in IRS audits:

• Improper tax-free treatment of certain fringe benefits provided to S corp shareholder-employees and members of their families.

• Running personal expenses through S corps in order to “transform” nondeductible expenditures into what appear to be deductible business expenses.

• Failure of shareholders to report income items passed through from S corps.

• Failure of corporations to comply with qualification rules that must be met to properly elect to be treated as an S corp.

• Failure to make valid S corp elections under the applicable procedures.

• Insufficient tax basis in S corp stock to deduct losses passed through from S corporations.

Bottom line: Running a business as an S corp is often a smart tax strategy. However, the tax rules for S corps can be tricky and there are potential traps for the unwary. Beyond that, the IRS knows some taxpayers have used S corps to evade taxes.

In any case, now is a good time to make sure your S corp is not over-exposed to adverse tax issues in the event of an IRS audit. You might want to consider conducting a “self-audit” to highlight any problems and take corrective actions before the IRS comes calling. Your tax adviser can help with that, and at the same time, assist you in collecting the maximum amount of tax savings allowed under the law.