IRS Scrutiny of S Corporations on the Rise

Some businesses elect to be treated as S corporations for income tax purposes. Named after Subchapter S of the Internal Revenue Code, S corporations benefit from having their income, losses, deductions, and credits flow through the shareholders' personal income tax returns rather than being taxed at the corporate level. This allows the business to be taxed at personal rather than corporate tax rates and eliminates double taxation on corporate profits. In general, the S corporation designation confers the benefit of limited liability for owner/shareholders while allowing for a favored tax position.

Shareholder-employees of an S corporation are required by the Internal Revenue Service (IRS) to be paid what is considered reasonable compensation for their services to the business. If the IRS believes the wages paid to the shareholder-employee are not reasonable, they may reclassify corporate distributions as wages. Why is it so important that reasonable compensation is paid in the form of wages? Wages are subject to employment taxes and corporate distributions are not. The IRS considers it tax evasion when S corporation shareholders perform services for the corporation and take no payment in the form of wages or are paid less than reasonable compensation for their services.

S Corporation Election

The S corporation election is limited to corporations that meet the following requirements:

• Must be a domestic corporation
• Has only allowable shareholders
  • including individuals, certain trusts, and estates and
  • may not include partnerships, corporations or nonresident alien shareholders
• Has no more than 100 shareholders
• Has only one class of stock
• Must be an eligible corporation (i.e. cannot be certain financial institutions, insurance companies, and domestic international sales corporations).

Determining Reasonable Compensation

When determining compensation, first consider where gross receipts of the corporation come from. Potential sources may include services of the shareholder, services of non-shareholder employees, and capital and equipment. If a majority of the gross receipts come from shareholder services, then a majority of the profit distribution to shareholders should be considered compensation or wages subject to all relevant payroll taxes.

In addition, IRS lists the following as important factors in 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

Medical Insurance

The treatment of medical insurance premiums paid on behalf of the shareholder-employee is also important to understand for S corporations. For shareholder-employees owning greater than 2 percent of the S corporation, health and accident insurance premiums that are paid by the corporation are included as wages on the shareholder-employee's W-2 and are deductible by the S corporation. These payments are not subject to social security, Medicare, or unemployment taxes.

IRS Scrutiny

Scrutiny of S corporations by the IRS has been heightened with the realization that many single-shareholder S corporations are not taking payments in the form of wages when the shareholder performs a high level of service directly related to the generation of gross receipts for the business. This can lead to billions of dollars losses in payroll tax losses.

Businesses having one owner are often times incorporated for the purposes of limiting liability, and they chose the S corporation designation for the purpose of a favored income tax position. However, there are areas where the business owner can get into trouble if he or she doesn't understand the different responsibilities that come with being an S corporation. A single owner corporation needs to ensure they do not operate as a sole proprietorship by following steps such as:

• Maintaining separate business bank accounts
• Not running personal transactions through the business
• Maintaining corporate minutes for all major business decisions
• Understanding and adhering to all relevant regulations, including shareholder-employee reasonable compensation and the treatment of medical insurance premiums

Looking for cost-effective payroll and retirement solutions for your S-Corporation? Contact us today.