With the well publicized budget deficit issues facing the nation, the IRS is becoming more aggressive in its search to close the “tax gap”. As Forbes magazine noted, “the Internal Revenue Service has increased the hours it spends auditing small businesses...by 30%, while reducing the time it spends auditing large corporations...by 33%.” [italics added] One area ripe for both taxpayer abuse and IRS inquiry is characterization of shareholder payments from Sub-chapter S corporations. Recent statistics suggest that Sub-S shareholders have figured this out. “Over the past decade and a half...the salaries of Sub-S owners declined as a percentage of total income from 52% in 1995 to 39% in 2007… During the same 12 year period, Sub-S income doubled, while salaries increased only 26%.”
Profits earned by an S-corporation are taxed as income at the individual shareholder level whether actually distributed or not. S-corp payments that represent dividends escape Social Security and Medicare taxes. Remuneration for services rendered, however, are considered wages and are taxed accordingly. The issue facing the small business shareholder is how to properly characterize compensation between dividends and wages. S-corp shareholders face the danger that the IRS will reclassify dividend distributions as wages subjecting them to both payroll taxes and substantial interest and penalties on their late payment. Further, loans to shareholders from S-corps carry the same risk. The IRS may claim that these loans are not at arms length and actually represent taxable income.
Due to several recent high-profile court cases on this subject, the tax court has highlighted several key factors that determine 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; and
● The use of formula to determine compensation.
With the still unresolved budget issues and an increased IRS emphasis on enforcement, these collection matters are not going away soon. Call the Rodeheaver Group and see how we can help you safely navigate these issues now before they become a problem in the future.
 Zerbe, Dean. “IRS Audits Small Biz More, Big Guys Less”. Forbes Magazine Online 4/11/10.
 Sanders, Laura. “The IRS Targets Income Tricks”. WSJ Online 1/22/11.
 Walters Kluwer. “Tax Research Consultant v 402.40” Anonymous Author. Copyright 2013.