Current Developments

S Corporation Compliance Initiative Will Help the IRS Select and Audit Returns
 
In July 2005, the IRS launched an important study to assess the reporting compliance of S corporations (News Release IR-2005-76). The study, carried out under the National Research Program (NRP), would involve 5,000 randomly selected S corporation returns from tax years 2003 and 2004.

"The use of S corporations has exploded," said then-IRS Commissioner Mark 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 their fair share."

The last reporting compliance study of S corporations involved about 10,000 returns from tax year 1984, prior to the tax law changes that spurred the growth in S corporations. The results of the current NRP study will be used to more accurately gauge the extent to which income, deductions, and credits from S corporations are properly reported on Form 1120S and the shareholders' returns. When completed, this research will help the IRS select and audit S corporation returns with greater compliance risk.

On August 2, 2007, the IRS noted in "Reducing the Federal Tax Gap: A Report on Improving Voluntary Compliance" that since 1985, S corporation return filings have increased dramatically. In that year, there were 722,444 Forms 1120S filed. In 2004, that number had grown by nearly five times to over 3.6 million, while other corporate returns declined by approximately 500,000 for the same period (News Release IR-2007-137).

By 1997, S corporations had become the most common corporate entity. In 2004, tax returns filed by S corporations accounted for over 63% of all corporate returns filed. As already noted, the last time the IRS conducted an S corporation study was 1984. As a result, the IRS does not have reliable reporting compliance data for these entities. The current S corporation study represents the first time that the IRS has conducted a reporting compliance study across tax years, and it will require that the data be "knitted together" to provide a comprehensive picture. The study will continue through 2007.

What does this Study Mean?

The intent of the current NRP study is not just to gather information, but to strengthen and refocus the IRS's compliance efforts. In News Release IR-2007-137, the IRS stated that: "Without up-to-date studies in all areas, the IRS is hampered in its ability to respond rapidly to trends and emerging vulnerabilities in the tax system. A multi-year commitment to research ensures that the IRS can efficiently target resources and effectively respond to new sources of noncompliance as they emerge."

Because of the limited size of the NRP study, most practitioners have not been directly affected. However, practitioners will be impacted in the next few years by the results of the study. While the IRS has not officially announced the issues or areas it is particularly interested in, experience and past statements by the Commissioner, the U.S. Government Accountability Office (GAO), and the Treasury Inspector General for Tax Administration (TIGTA) indicate that problematic areas include:

• Compensation paid to shareholders who perform services.
• Basis--debt basis in particular.
• Compliance with the 2% shareholder fringe benefit rules.
• Allocations of income (no special allocations as with partnerships).
• Passive activity loss issues (e.g., rental income not recharacterized).
• Misreporting or ignoring the built-in gains tax or the passive activity income tax.

Unreasonably Low Compensation for Shareholder-employees

While "unreasonable comp cases" historically have involved compensation that is too high (to avoid the double taxation of C corporation earnings), substantial tax advantages can be gained by S corporations paying unreasonably low compensation. For example, shareholders who are in a high individual income tax bracket may reduce compensation to increase pass-through income. When children or parents are also shareholders, their increased share of pass-through income may be taxed at a lower rate.

Furthermore, compensation is subject to payroll (FICA and FUTA) taxes, while pass-through income is not. Pass-through income and distributions are not subject to self-employment tax, either. Since the increased pass-through income resulting from a lower compensation deduction increases each shareholder's stock basis, thereby permitting distributions without additional income or employment taxes, it can be to an S shareholder's advantage to reduce or eliminate salary and withdraw funds from the corporation with distributions instead. Doing so will reduce or eliminate FICA taxes on both employee and employer, and reduce or eliminate unemployment taxes as well.

The IRS is well aware of these strategies for reducing or eliminating S corporation compensation, particularly the strategy for minimizing salaries to reduce payroll taxes. Reportedly, it has developed filters to identify S corporation returns for audit that appear to have relatively small salaries in relation to profits. Additionally, it has made outreach efforts to ensure that S corporations are aware of the requirement to treat reasonable compensation to S corporation officers as wages for employment tax purposes.

Two TIGTA reports ("The Internal Revenue Service Does Not Always Address Subchapter S Corporation Officer Compensation During Examinations" and "Actions Are Needed to Eliminate Inequities in the Employment Tax Liabilities of Sole Proprietorships and Single-shareholder S Corporations") also discuss the issue. The first TIGTA report, issued in 2002, was based on 84 S corporation returns that reported officer compensation of less than $10,000 and ordinary income greater than $50,000. The average wages reported on the selected returns was $5,300 while the average distribution was $349,323. The second report, issued in 2005, reported that in 2000, approximately 36,000 single-shareholder S corporations with profits of $100,000 or more passed through total profits of $13.2 billion to their owners without paying any employment taxes.

The reports conclude that the continued underpayment of reasonable salaries results in the large underpayment of FICA taxes, and encourage the IRS to proactively pursue the issue. Furthermore, several Tax Court cases, all of which have been affirmed by the 3rd Circuit, reinforce the IRS's interest in the understatement of S corporation shareholder-employee compensation (e.g., see Joseph M. Grey Public Accountant; Veterinary Surgical Consultants P.C.; and Specialty Transport Delivery Services, Inc.).

To summarize, the IRS and the courts have made it increasingly clear that distributions to an actively employed S corporation shareholder will be recharacterized as wages subject to payroll taxes if the distributions are actually disguised compensation.

Generally speaking, taxpayers will not prevail when the compensation is extremely low. While the "reasonableness" determination is based on the facts and circumstances, in many situations compensation can be set at the low end of a wide salary range that is both reasonable and supportable. The better the documentation (e.g., in the corporate minutes) why the amounts characterized as wages are reasonable and appropriate, and the greater the business purpose for transactions between the S corporation and its shareholders, the more likely that the transactions will withstand IRS attack.

Increasing Shareholder Basis

The fundamental purpose of tax basis is to account for an owner's investment in the S corporation. Tracking basis is important for the following reasons:

Losses allocated to shareholders reduce their basis. Once a shareholder's basis is zero, the deduction of additional losses is suspended until the shareholder has basis to absorb the loss. Accordingly, basis determines the allocable share of company pass-through losses that can be used to offset noncompany income.

Basis determines whether gain or loss is recognized when the shareholder receives distributions (whether in cash or property) from the company. As long as the shareholder has basis, distributions that are treated as a nontaxable return of capital investment (as opposed to dividend distributions) merely reduce the shareholder's basis by the amount distributed.

Finally, basis governs gain or loss on the sale of stock. If the amount received on disposition is more than basis, a gain is reported. If the amount received is less than basis, a loss is reported. Generally, the gain or loss is capital.

While basis is increased by the flow-through of company income, basis can also be generated by contributing cash to the corporation or buying additional stock. A shareholder can also increase basis by loaning cash to the entity. If the shareholder lacks the funds necessary to make the loan, a "back-to-back" loan can be used, where the shareholder borrows funds from a third party lender and relends them to the company.

Observation: Since a loan does not create an increased ownership interest, an increased allocation of losses will not result. This means that an additional investment increasing the shareholder's ownership interest relative to that of the other owners may be preferable for tax purposes because it will generate basis and increase loss allocations.

Basis problems often result from the fact that, unlike a partner, an S corporation shareholder does not increase basis by a ratable share of corporate indebtedness to third parties. Instead, once an S corporation shareholder's stock basis has been reduced to zero, pass-through losses and deductions can be deducted only to the extent the shareholder has debt basis in direct loans to the S corporation. This is true even when the loan is from another entity that is entirely or predominately owned by the shareholder (Donald Oren), or the note shows the corporation and the shareholder as co-borrowers (Richard Salem).

Attempts to claim additional basis from a shareholder guarantee of S corporation debt have, for the most part, failed. For example, see Estate of Daniel Leavitt, where the court rejected the taxpayer's argument that a bank loan to the corporation guaranteed by the shareholder should generate debt basis because the bank would not have made the loan without his guarantee. The lone taxpayer victory was in the 11th Circuit Edward Selfe case. However, the facts of that decision limit its usefulness for tax planning--the corporation was thinly capitalized, and the debts in question were originally personal loans to the shareholders that were converted to corporate-level debt upon incorporation.

Although guaranteeing S corporation debt generally does not generate basis, when S shareholders pay corporate debt they have guaranteed, debt basis is generated because the corporation owes the debt directly to the shareholders (Rev. Rul. 71-288). Shareholders can also receive basis from substituting their own notes for the corporate debt carrying their guarantee, provided the corporation is released from its debt (Rev. Rul. 75-144).

When a shareholder loans funds to an S corporation, the corporation should execute a written note containing commercially reasonable terms that bears an interest rate at least equal to the applicable federal rate (AFR). Doing so may help blunt an IRS argument that the shareholder loans are not bona fide debt.