Is the IRS About to Attack "S" Corporations?

by Kevin T. Downs

The Inspector General for the Treasury Department recently released a report entitled "The Internal Revenue Service Does Not Always Address Subchapter "S" Corporation Officer Compensation During Examinations." This report may be the prelude to the IRS focusing on the issue of understated compensation in "S" Corps.

First, a little background. "S" Corporation taxpayers are able to save taxes by limiting the compensation paid to shareholder employees. By reducing the compensation, the Social Security and Medicare taxes (the FICA taxes) are also reduced. The "S" Corp. then passes its "profits" to the shareholder as "distributions". As long as the compensation is reasonable, then the distributions are not subjet to the FICA taxes. "S" Corporations typically pay a modest amount of compensation; distributing the remaining cash as a distribution. On audit, if the IRS successfully challenges the amount of compensation as unreasonable, the corporation can be assesses back taxes, penalty and interest. This has not been a major concern in "S" Corporation audits.

Now, the Inspector General's report indicates that this issue may come to the forefront. The report shows that in 1998, more than 2.6 million "S" Corporation returns were filed. Of these, 5% reported under $10,000 of Officer Compensation, while reporting more than $50,000 of distributions. The auditors then went further in examining some of the returns. They found that of the returns examined, the average W-2 form showed wages of $5,300. The average distributions for these same returns were $349,323! The report goes on to say that there seems to be a pattern of paying unreasonably low compensation to avoid FICA taxes. The report suggests a nationwide monitoring of "S" corporation compensation.

Earned Income Tax Collectors would be well advised to carefully review "S" Corporation compensation reported on the local returns. I suggest that you review the information available on the IRS website (www.irs.gov) in the Tax Professionals section.