S Corporation Tax Problems, IRS S Corp Tax Issues, IRS S Corp Audit

S corporations tax challenges by the IRS and other taxing authorities

Tax Advocate’s Report highlights S corporation issues

Despite the fact that Subchapter S corporations are the most common corporate entity (over three million S corporations filing returns in fiscal year 2006), the National Taxpayer Advocate’s 2007 Annual Report notes that IRS is still struggling to develop an effective and comprehensive strategy to address noncompliance by S corporations. The Report focuses on some of the challenges in this area, including insufficient data to assess compliance risks and undue taxpayer burden because of the S corporation election process and Schedule K-1 matching errors. In particular, the Report examined the avoidance of employment taxes by means of treating shareholder wages as distributions.

Background. S corporations are incorporated entities with many of the same attributes as traditional C corporations, including limited liability, transferable ownership, and unlimited life. But unlike C corporations, S corporations are generally not subject to income tax. Instead, the business’s profit or loss is passed through to the shareholders, who report it on their individual returns. To qualify, a corporation must elect S corporation status and meet a number of requirements. It can have no more than 100 shareholders, and only certain types of taxpayers can be shareholders. It can have only one class of stock.

The Report surmises that the continual growth in S corporation filings–which account for 65% of all corporate returns–may be due in part to the lower individual tax rates available, limited liability, and the perceived opportunity for sole proprietors to avoid self-employment tax.

Compliance data difficulties. IRS stratifies S corporation filings into three separate asset ranges (as compared with the 13 ranges for C corporations). This can make identifying returns with higher compliance risk more difficult, especially when 99% of all S corporation returns report assets of $10 million or less. In fiscal year 2006, an S corporation faced only a 4 in 1000 chance of being audited, compared to 8 in 1000 for C corporations.

The Report notes that IRS increasingly identifies S corporation returns for examination to address abusive tax schemes and avoidance transactions, but identifying compliance risk associated with multi-entity return groups is challenging. (IRS is also developing a high income taxpayer strategy to test the hypothesis that the highest income strata of Forms 1040, Individual Income Tax Return, are using a variety of tax products and entity structures to defer tax liability into future years, convert ordinary income into lower capital gain tax income, or offset income with sham losses.)

When IRS proposes changes to S corporation returns at the conclusion of an examination, it reports each shareholder’s distributive share of the change as an adjustment to the individual shareholder’s tax return. In addition to certain deficiencies with the audit process, IRS is unable to measure its effectiveness in S corporation examinations because it doesn’t track the ultimate tax at the Form 1040 level. IRS records audit results at the S corporation level but never associates them with the tax assessment.

S elections and K-1 filings. Taxpayers elect S corporation status by filing Form 2553, Election by a Small Business Corporation, on or before the 15th day of the third month of the tax year for which the election is to be in effect. If the election isn’t timely filed or is incomplete, the S corporation return is converted to a C corporation return when filed. In past years, roughly 14% to 16% of total new S corporation filings were unpostable (i.e., the S corporation election was not approved). Approximately 20% of S corporation returns are unpostable for multiple years because of missing information or IRS processing errors.

S corporations file Schedules K-1 each year to report profit and loss to their shareholders. IRS then matches income and loss information from Schedules K-1 to individual tax returns and generates notices when differences arise. Although returns are screened to eliminate unnecessary notices, the error rate is still high. IRS technicians who work discrepancies have limited accounting and tax training, while S corporation returns contain many complex issues that may go undetected where employees only address flow-through income. Further, since the K-1 matching program is part of the Automated Underreporter (AUR) program unit, which limits human involvement, many taxpayers are unable to reach a trained IRS employee to answer questions concerning mismatched K-1s because the AUR program’s level of service is poor and the program has no dedicated line for practitioners.

The Report concludes that IRS needs to focus on reducing taxpayer burden associated with the S corporation election process and the K-1 matching program. Taxpayers and return preparers have identified the S corporation election process as one of the most difficult for eligible small business corporations. While efforts have been made to simplify the S-election process and reduce processing costs, the Report concludes that the best approach to reducing taxpayer burden is to permit the election to be considered timely filed with the first S corporation return. Taxpayers and practitioners need access to knowledgeable IRS employees to deal with the often complex questions regarding S corporation and K-1 matching issues.

Compensation vs. corporate distribution. The earnings of an S corporation are taxed as ordinary income to its shareholders. Unlike partnership or sole proprietor earnings, S corporation earnings are not subject to self-employment tax. This treatment gave rise to a tax planning strategy that recharacterizes shareholder compensation as distributions of profit to avoid payroll taxes. The S corporation owner pays employment taxes on only the portion of profits that he arbitrarily decides is “salary.” The S corporation officer or shareholders, who takes no salary or a nominal salary, receives the remaining compensation as tax-free distributions. The corporation saves payroll taxes, and the shareholder pays only income taxes on his share of the corporate profits, avoiding paying Social Security and Medicare taxes.

In tax year 2005, almost one million S corporations with one shareholder paid no officers’ compensation. The Report calculates that if all profitable S corporations that reported no officers’ compensation had been Schedule C businesses, they would have paid an estimated $4.9 billion in self-employment tax.

The Report notes that the wage-to distribution conversion strategy may reduce the shareholder’s future Social Security benefits–an important part of most individuals’ retirement income. A taxpayer’s Social Security benefits depend on the amount of pre-retirement wages received and social security taxes paid.

Although IRS has repeatedly litigated this issue and has won, taxpayers continue to use it as a tax planning strategy. IRS acknowledges this issue as a special compliance problem, featuring it in corporate classification guidelines for Form 1120S and including a reference to it in its notice of acceptance of S corporation status. IRS continues to audit returns based on this issue and reclassify distributions as wages subject to employment taxes. But establishing a fair and reasonable wage is difficult and time consuming. IRS examiners must consider: the financial condition of the corporation; the time worked by the shareholder; the company’s compensation policy for other workers; the salary structure in companies in similar industries; and the return on investment.

Observation: The easiest cases for IRS to litigate and win are those where a sole S corporation owner claims no or negligible salary subject to employment taxes despite the fact that he may serve in key roles in the business, providing management, sales, or service functions, controlling the day to day activities of the company and making decisions affecting its future. The much more difficult and thornier cases are those questioning whether a salary that is not negligible is sufficient, i.e., reasonable.

The Report concludes that actions are needed to reverse the trend of electing S corporation status to avoid Social Security taxes. The employment tax strategy has an economic impact on the tax gap and erodes the Social Security and Medicare tax base. While acknowledging the challenges faced by IRS in dealing with this compliance issue (while reducing taxpayers’ burden), the Report concludes that IRS must find the right balance of research, training, outreach, and compliance activities to improve the quality of S corporation work.

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Mike Habib, EA