Heightened scrutiny for S corporations – auditing of small corporations
The Internal Revenue Service has stepped up its audits of S corporations to catch owners who cheat on FICA self-employment taxes. “One of the reasons we are increasing our audit coverage of small [S] corporations is the issue of officers not counting themselves as employees and distributing everything as a profit to avoid the self-employment tax on wages,” says Bill Roth, IRS director of corporate examination programs.
In 1988, 1.2 million S-corportion returns were filed, and 7,331 were audited. In 1992, the most recent year for which figures are available, returns had climbed to 1.8 million and audits to 18,466.
“What they’re looking for is unpaid Social Security and Medicare taxes,” says Paul Offenbacher, president of Offenbacher & Co., a Silver Spring, Md., accounting firm. If the money is paid to corporate officers as a distribution of profits, it is not subject to FICA (Federal Income Contribution Act) taxes, which amount to 15.3 percent of wages paid (12.4 percent for Social Security and 2.9 percent for Medicare).
In partnerships, limited-liability companies, and sole proprietorships, all income flowing to partners and owners is subject to FICA taxes. S corporations–which pass all income and losses to shareholders (owners), who report it on individual tax returns–may distinguish between salary and profit for FICA tax purposes.
Roth says compliance with employment-tax regulations, which require payment of a “reasonable” salary, has slipped from 80 percent to 60 percent in recent years.
A recent case, Dunn & Clark vs. Commissioner of Internal Revenue, illustrates the compliance problem. A federal court found two attorneys operating as an S corporation failed to pay themselves salaries. They took compensation as a distribution of profits instead, bypassing FICA.
The court ruled that the attorneys “were employees of the corporation for employment tax withholding purposes [and] the corporation had no reasonable basis for not treating the attorneys as employees.” As a result, the attorneys had to pay a total of $12,300 in back taxes and penalties. The figure, which was calculated by the IRS, reflected employment taxes that the attorneys would have owed if they had paid themselves “reasonable” salaries during the years in question.
The concept of reasonable salary is central to understanding S-corporation taxes. Suppose, for example, a consulting firm pays its three officers $10,000 each in salary and $50,000 each as distribution of profit. When their S-corporation tax return is audited, the IRS learns that all three officers have worked full time. Since consultants in comparable lines of work typically earn $50,000 or more a year, the IRS rules that each officer should have received $50,000 in salary and $10,000 as distribution of profit.
Roth suggests using an “arms-length approach” to determining reasonable compensation: “If you had no ownership interest [in the company], what would be your salary?” Such an approach gives the company owners considerable protection in an audit situation, says Roth.
A “reasonable” distribution of profit can also be calculated. In general, S-corporation owners are entitled to a reasonable return on their investment. Let’s say you invested $500,000 in your business over the years. You could expect at least a 10 percent return if you had put it in the stock market. That’s the average annual return on publicly traded stocks for the past 25 years.
Let’s also say that your company has $100,000 to distribute to you as salary, or profit, or both. Using the 10 percent return-on-investment approach, you could take $50,000 as a return on your $500,000 investment and a salary of $50,000.
You could justify a larger profit distribution if you had cut back on your hours by delegating management responsibilities. If you worked just three days a week, you could cut your salary to $30,000 and take $70,000 as a profit distribution.
By carefully calculating salary and profit, S-corporation owners can minimize the chances of being audited. The IRS has programmed its computers to flag S-corporation tax returns that show big profit distributions and little or no salary. The IRS simply compares Line 7–Compensation of Officers–on the front page of an S-corporation tax return with Line 21–Net Profit From Trade or Business. If Line 21 shows a large sum and Line 7 shows little or nothing paid in salaries, then the return is a good candidate for an audit, Roth says.
“The key to keeping the IRS off your back is determining what kind of salary and profit distribution will pass the screen,” Offenbacher says. “It’s awfully tempting to say that you got no salary or a very small salary. But this practice is becoming increasingly dangerous. Once [IRS auditors] get into the audit process, they can go back three to five years and collect a whole list of unpaid taxes and penalties.”
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