Tax authorities seem to have taken the first steps toward closing a reporting loophole for S corporations.
The Treasury Inspector General for Tax Administration (TIGTA) reports that the IRS is selecting a tiny number of all S corporations for examination for compliance with payment of employment taxes. When the IRS does examine an S corp, an August TIGTA report says, many revenue agents don’t look closely enough at executive compensation.
The TIGTA asserts that of the 14.8 million income tax returns filed by S Corporations for calendar 2016 through 2018, only 32,000 were audited by the IRS—less than one quarter of 1% for each year, said James G. McGrory, a CPA and shareholder at Drucker & Scaccetti in Philadelphia.
Of those selected, officer compensation was selected as an issue during classification 14% of the time, added Miri Forster, partner and co-leader of the Tax Controversy Practice for Eisner Advisory Group in New York. “With a population of 30% of S corporation returns having a single shareholder and no officers’ compensation reported, the report claims that the IRS exam rate of officers’ compensation does not match up with the potential risk,” Forster said.
Forster said that the IRS compliance campaign focused on whether certain S corporation distributions have been properly taxed and looks at three types of distributions: those of appreciated property where the S corporation fails to report gain; when an S corporation fails to determine that a distribution is properly taxable as a dividend; and when a shareholder fails to report non-dividend distributions more than their stock basis that are subject to tax.
The IRS countered that during the pandemic the TIGTA didn’t have access to complete examination case files of the S Corporation tax returns, and the agency's inadequate compensation is “one of the many issues that are looked at by revenue agents,” McGrory said.
With heightened enforcement now a possibility, the tax and reporting structure of clients’ and advisors’ S corporations needs close attention.
For example, S corporation owners who work in their companies have “a significant advantage” over partners in a partnership because flow-through income on Form 1120S, Schedule K-1, is not subject to self-employment tax, McGrory said. “Conversely, partners, who actively perform services for their Form 1065 partnership are subject to self-employment tax on their share of ordinary income that is passed through to them.
“This may motivate some S Corporation owners to underpay or not pay themselves W-2 compensation and instead take their compensation through shareholder distributions, avoiding employer and employee FICA and Medicare taxes altogether,” he said.
“Also, shareholders tend to have difficulty tracking and properly calculating their basis in the S corporation,” Forster said. “As a result, shareholders may claim losses and deductions from the S corporation without enough basis to absorb those items. The IRS has been conducting examinations and issuing ‘soft letters’ to shareholders to strengthen compliance.”