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    Treasury Tells IRS To Turn Up Heat On S Corp Underreporting Of Owner Compensation

    Single-shareholder S Corporation owners have incentives to minimize the wages they receive in order to avoid employment taxes. Unlike wages, shareholder distributions are not subject to employment taxes. Also, the qualified business income does not include owner compensation for purposes of the 20% passthrough deduction.

    The tax law requires that distributions to a corporate officer should be treated as wages to the extent the amounts are “reasonable compensation” for services rendered to the corporation. If owners are performing significant services to the company and not claiming W-2 income, the IRS can re-characterize the distributions as wages and penalize the taxpayer for understating wage income.

    Not Enough Audits

    Treasury Department auditors recently examined IRS’s procedures for ensuring that closely held S Corporations are paying adequate compensation to their owners. They are not, according to a report by the Treasury Inspector General for Tax Administration (TIGTA). In fact, a number of S Corporations pay no salaries at all, allowing their officers to avoid employment taxes. The IRS is not auditing enough of these returns, Treasury found.

    TIGTA’s analysis of S corporation returns received between 2016-2018 identified 266,095 returns with profits over $100,000, a single shareholder, and no officer’s compensation claimed that were not selected for IRS field examination. Treasury estimates that these returns represent nearly $25 billion that should be compensation resulting in avoidance of approximately $3.3 billion in FICA tax.

    What IRS is Doing Wrong

    The IRS is selecting less than 1% of all S corporations for examination, TIGTA says. When it does examine S corporations, nearly half of the revenue agents do not evaluate officers’ compensation even when single-shareholder owners may not have reported any officer’s compensation. In short, TIGTA believes the IRS is not prioritizing this issue. S Corporation returns on Form 1120-S can be examined for many reasons, such as meals and entertainment, educational expenses, gifts and awards, public relations, royalties or fuel tax credits, TIGTA notes, but the important issue of officer compensation is often not evaluated during field examinations of Form 1120-S.

    What TIGTA Recommended

    TIGTA recommends that the IRS Small Business/ Self-Employed Division consider the use of a threshold and specific criteria to identify whether officer compensation should be a main focus in examinations. The IRS also should use its existing workstreams and should perform a noncompliance risk analysis to determine audit priorities for closely held S Corporations. Existing audit statistics for the compensation issue are too low to be a deterrent, TIGTA contends.

    IRS Disagrees

    The IRS responded to TIGTA’s report by stating, “We believe our existing policies and procedures address compliance risk regarding officer’s compensation.” The IRS, citing the burdens COVID has placed on the agency, also argues that expending more resources to target more of these potentially non-compliant returns “could result in little or no net tax assessed.” The IRS believes TIGTA’s audit statistics are understated–that, in fact, less than 9% of S Corporations did not issue a W-2 to its shareholder.

    The IRS also said its examiners are trained to properly identify inadequate compensation, and the use of a threshold could cause IRS to disregard issues of greater noncompliance than officer compensation.

    In short, the IRS looks defensive on this issue but with Treasury looking over its shoulder, S Corporations can expect that the IRS may start paying more attention to the compensation levels.

    How Much Compensation Is Enough?

    The determination of whether compensation paid for services rendered by officers is reasonable is based on the facts and circumstances of each case. This issue is regularly litigated, with the various courts looking at factors such as the type and amount of services performed, salary comparisons in the industry, and the proportion of salary to dividends. The IRS lists the factors that should be considered when determining reasonable compensation.

    • Training and experience
    • Duties and responsibilities
    • Time and effort devoted to the business
    • Dividend history
    • Payments to non-shareholder employees
    • Timing and manner of paying bonuses to key people
    • What comparable businesses pay for similar services
    • Compensation agreements
    • The use of a formula to determine compensation

    While there is no one magic formula, if an owner performs substantial services and does not claim any compensation, the taxpayer is inviting an audit. The risk is particularly high in single-shareholder S Corporations where the owner performs professional services that make up the main business activity of the company. Vulnerable owners include such professions as lawyers, doctors, accountants, engineers, architects and real estate professionals.

    It is important to consult with your tax adviser when setting compensation for services performed for your S Corporation. Owner salaries must be defensible based on the amount and nature of the services.

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