The federal budget deficit is projected to reach a record of $1.5 trillion in 2011 due to the weak economy, higher government spending, and new tax cuts. That being said, the government has to make up the deficit somewhere – and looking to existing tax laws is going to be a favorite place for the Internal Revenue Service to start. S Corporations are coming into scrutiny as never before.
An S corporation is defined as a corporation that, for Federal income tax purposes, is not considered to be a tax-paying entity and is not subject to paying income taxes. Instead, the corporation’s income or losses are divided among and passed through to its shareholders. The shareholders must then report the income or loss on their own individual income tax returns.
The number one audit risk for S corporations is salaries paid to officers of the corporations. Because no payroll taxes are paid on the distributed profit of an S corporation, many owner/employees of S corporations do not pay themselves wages to avoid payroll taxes such as FICA, Medicare, federal unemployment, state unemployment, and workers’ compensation on both the employee and employer levels.
It is assumed by the IRS that no one works for free. Therefore, the IRS is actively searching out S corporation tax returns that do not show a reasonable salary paid to the owner/employees even if the corporation is losing money.
What is a reasonable salary? The salary should be based on the same criteria as for non-shareholders such as market rates, knowledge, skills, and hours worked. Salary is reasonable if a non-shareholder would be willing to accept the job at the same salary. If the S corporation is losing money, it would be prudent to keep a record of the number of hours worked in the business to substantiate the salary.
What is an unreasonable salary? Again, no one works for free, so no salary is unreasonable.
If the IRS determines that the salary of an S corporation owner/employee is unreasonable, it can collect payroll taxes that would have been due on that reasonable salary as well as a penalty for failing to file payroll taxes of 100 percent of the taxes due! The IRS will no doubt tell you what that salary is. The U.S. District Court in Iowa recently added $70,000 of distributions to the taxable wages of an S corporation owner/employee for each of two years plus penalties and interest due on the recharacterized amounts.
This issue is so important to the IRS that in May 2010, it was proposed that S corporation distributions paid to an owner/employee be subject to self-employment tax. That proposal was not included in any 2010 legislation, but you can be sure it will not be forgotten.