IRS is challenging S Corporation compensation

There is an increased IRS audit risk for S Corporation shareholders. The service is increasing audits to determine reasonable compensation to shareholder/officers. If a controlling shareholder receives little or no compensation for services rendered to the corporation and instead receives distributions, the IRS may recharacterize a portion or all of the distributions as compensation for services per IRS Revenue Ruling 74-44. There also is an audit risk of shareholder loans recharacterized as compensation.

The amounts recharacterized as reasonable compensation are subject to employment taxes which amount to 15.3 percent of the compensation. The IRS audit guidelines are somewhat vague and based on economic realities. Since there are no specific guidelines for reasonable compensation in the IRS code or regulation, the courts have ruled on the facts and circumstances of each case.

Some tax professionals believe that the IRS is following the rule known as the outside investor return guideline. The audit guideline presumes that an outside investor expects between 10 percent and 20 percent investment return per year for a privately held investment since privately held small and medium-sized businesses are high risk investments. The audit examination may change the S Corporation to reflect income of the equivalent 10-20 percent return and back into the officer/ shareholder salary amount accordingly.

The court ruling factors to consider are training and experience; duties and responsibilities; time and effort devoted to the business; and dividend history to name a few.

Certain strategies as noted by the Journal of Accountancy reduce the likelihood of this type of IRS audit. Enclosed are a few common strategies:

1) Minimize the audit risk by reporting at least compensation equal to the FICA Social Security limit which is $118,000 for 2015. In circumstances where there are no distributions, shareholder loans, or shareholder compensation, the risk of audit may be lower because there would no economic benefits received by the officer/ shareholder. These circumstances are rare.

2) Another strategy is to identify Officers. Report both officers and officer / shareholders. S Corporations with total receipts over $500,000 are required to report officer compensation, percentage of stock held, and percentage of time devoted to the business.

3) Encourage shareholders to maintain written logs. Shareholders have the responsibility to proving how much time they spent and the services they provided. Although keeping contemporaneous logs is a challenge, it is vital in the event of an audit, because the IRS and Tax Court do not accept after-the-fact estimates.

4) Provide comparability compensation data. Various salary comparison services such as payroll and staffing services provide reliable industry salary data at a nominal cost. This industry and salary information should be compared to the salaries paid to the shareholder-employees of the company. The company should be able to explain any salaries outside the range of the comparable data that is either below or above it.

5) Encourage shareholders to minimize loans from the company. The IRS examines loan amount reported on Form 1120S, Schedule L, Line 7, loans to shareholders. If these loans remain unpaid, and if there are not a written promissory notes with regular interest payments, the loans may, under audit, actually be considered disguised compensation to the shareholders.

Keep these strategies in mind to minimize an IRS audit risk to your S Corporation. Also, as a general rule, when the IRS audits corporations and individuals, the service examines a minimum of the past three years of tax returns to determine compliance. As with complicated tax questions including this matter, seek the advice of a qualified tax advisor for further information and guidance.

Scott T. Wait, is a partner with RS Wait, Chtd. of Reno. Contact him at 775.825.7337 or scott@rswait.com.