the IRS Examination
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.
Corps are Growing More Popular
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
are some statistics about the increasing popularity of S
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
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.
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
“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
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
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
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.
While the IRS has not announced the
exact tax issues it will be focusing on in S corp audits, one
major focus will undoubtedly be low, below-market salaries
paid to S corp shareholder-employees in order to avoid payroll
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
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
- 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
- Failure to make valid S corp elections under the
- 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.