S Corporations: A Target of Missed Tax Revenue for the IRS?

S corporations are the fasted growing legal entity choice; there are approximately 4 million nationwide. With that, they have attracted the attention of Congress and the IRS to ensure reporting practices meet applicable standards. The IRS conducted audits on 2003 and 2004 S corporation tax returns as part of a “National Research Program.” The result? An estimated 68% of S corporations misreported their net income, understating their combined net profits by $85 billion.

Background - Why are S corporations attractive?
• S corporations do not pay corporate income tax. Instead, the earnings or losses are passed through to its shareholder(s) and the taxes are paid at the individual level.
• Opposed to other “pass-through” entities, such as partnerships, S corporation earnings are not subject to payroll taxes (self-employment tax reported on the individual income tax return). “Reasonable compensation” is required to be paid to S corporation owners in lieu of payroll taxes on passed through earnings.

Through the Eyes of the IRS - Missed Tax Revenue
If S corporation net profits are understated as reported in the IRS audit results above, those affected shareholders’ individual income taxes are understated as well. Furthermore, if the reasonable compensation requirement is ignored by setting an unreasonably low salary or even no salary at all, the payroll taxes on that amount are missed. As a result of the same IRS audits discussed above, S corporation owners were underpaid an estimated $24 billion in wages in accordance with the reasonable compensation requirement.

What is Congress going to do about it?
Although nothing has been passed to date, there is much discussion of raising payroll taxes to increase tax revenue. A Medicare tax rate increase and raising the Social Security tax on earnings above $250,000 are just a couple of ideas being kicked around. If payroll taxes are increased, you can bet the effort to enforce S corporations to pay reasonable compensation will likely increase as well.

Already paying a reasonable salary? Well, you still might not be safe. Other ideas that have made the paper: subjecting S corporation owners who perform services (i.e. doctors, accountants, attorney, etc) to Social Security and Medicare taxes on all of their earnings, and imposing payroll taxes on all earnings of any S corporation owner who owns more than 50% of the corporation.

In summary, there is no reason to shy away from forming or maintaining an S corporation. Rather, S corporation owners should make sure they are in compliance with the taxation rules by consulting their tax advisors for guidance and being prepared for increased IRS audits.

Stay tuned for the latest developments!