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Sensitive Audit Areas for S-Corps

Law360, New York (November 03, 2014, 2:29 PM ET) — S corporations are a highly popular tax structure for small businesses, thanks to their pass-through tax treatment, but as they increase in number, they’re also attracting increased scrutiny from the Internal Revenue Service, which is redoubling its taxpayer compliance efforts among individuals and closely held businesses, experts say.

It’s estimated that the U.S. has a $450 billion gap between taxes that are owed to the government and taxes that are actually paid on time. The staggering number has put taxpayer compliance back in the forefront for the IRS, after it shifted resources in the 1990s away from auditing activity and toward information and technology building, says Larry Brant, a tax partner with Garvey Schubert Barer.

S corporations combine the best aspects of the partnership and the corporation, allowing businesses to use a corporate form while funneling income and losses directly to the company’s individual shareholders like in a partnership so that the money is taxed at the individual level instead of at both the individual and the corporate levels, as is customary in C corporations.
And while audit risks for S corporations are generally small, the perks they enjoy are subjecting them to increased scrutiny, experts say.

“Taxpayers need to be on their game because the IRS is back in the audit business, and penalties are stronger than they’ve ever been before,” Brant said.

Below, tax experts share four common audit risk areas for corporations taxed under Subchapter S of the Internal Revenue Code.

Unreasonably Low Compensation

S corporation shareholders are heavily advantaged when they pay self-employment taxes because they pay payroll taxes only on income that is classified as wages, unlike sole proprietors, who have to pay self-employment taxes on all income. This loophole incentivizes S corporation shareholders to give themselves the lowest wages possible and take the rest of their income in the form of deductions. But the IRS is watching.

The agency often audits S corporations and their shareholders over unreasonably low compensation — an amorphous label that lacks a uniform standard within the courts and instead depends on questions of facts and circumstances, Brant says.
The IRS often goes after low-hanging fruit in such cases and audits taxpayers that report little or no income, but all S corporations and their shareholders should beware, experts say.

“What I tell our S corporation clients is that they want to annually document their compensation decisions, their rationale for shareholder employee compensation decisions,” Brant said. “This would include developing a compensation methodology based on qualifications, nature of work, information about what other companies pay. It’s an art.”

“More often than not, if you give the IRS a substantive explanation of how you reached that compensation, they tend to accept it,” Marcum LLP tax partner James Wienclaw said.

Insufficient Basis for Loss Deductions

When S corporations generate losses, their shareholders can deduct those losses up to the value of their investment in the company, otherwise known as their basis. But basis can change year to year and can be difficult to track. So when S corporations start to generate consistent losses, they may attract the attention of the IRS, which will want to ensure that the corporation’s owners have enough basis to take those losses, tax attorney Ronson Shamoun of the RJS Law Firm says.
Basis calculations can be difficult to make since S corporations aren’t required to report basis on their annual distributions to shareholders. Sometimes, shareholders will be aware of their basis because they are heavily engaged in the company’s inner workings, Brant says. But in many circumstances, shareholders won’t know their basis in the company, which creates substantial problems on audit.

“We try to track basis as best as we can as practitioners, but in situations where clients move around, basis analyses often lose integrity or get lost,” Wienclaw said.

S corporations themselves are best positioned to know and keep track of shareholder basis, and for that reason, it’s advisable that they share that information with shareholders on an annual basis, says Jason Watson of the Watson CPA Group.

Shareholder Loans

If S corporation shareholders receive loans from their companies, they should ensure the loans are backed by notes so as not to create unintended consequences, Wienclaw says.

S corporation distributions must be allocated in accordance with a shareholder’s ownership in the company, and if a loan is issued without a note, it can be classified as a distribution that upsets that balance, triggering an audit.

“The IRS can come back and say, ‘This isn’t a bona fide loan, and you have a disguised shareholder distribution.’ This will require other shareholders to receive their pro rata distribution to avoid termination of the S election or a potential gain on distribution,” Wienclaw said. “These are serious issues. When you borrow corporate funds, you really should have a note with an interest rate to legitimize the loan and put substance to it because substance usually carries over form.”

Watson says S corporations should work to resolve these loans as quickly as possible.

“Sometimes you just have to create a loan so your balance sheet balances. You can get away with that for a year, but you want to get that cleared up right away so that typically by the time the IRS catches up with you, you can explain that you’ve already fixed the matter .”

Ineligible Shareholders

S corporations can only have certain kinds of shareholders — such as individuals, estates and certain trusts — and cannot count partnerships and foreign owners among their ranks. Occasionally, S corporations will unwittingly issue new stock to ineligible shareholders and inadvertently terminate their status, so these corporations have to be vigilant about the shareholders they bring into their midst, Wienclaw says.

“The IRS has gotten more lenient on these issues, so if you make a good faith effort to correct the problem in a very timely manner, they may allow you to correct that mistake,” he adds. “But you need to show that you tried to fix things in an expedient manner.”

–Editing by Kat Laskowski and Christine Chun.