Is that the sound of the air being let out of the tires of the growing trend towards S corporations?
Perhaps. The IRS announced plans on Monday, July 25, to randomly audit 5,000 S Corporation returns (federal forms 1120S) this year as part of a study to “assess compliance.” In IRS speak, that means that there is a concern about fraudulent reporting.
The S corporation is, according to IRS, the most commonly reported tax entity, representing more than half of all corporate returns filed for the 2002 tax year, the last year for which data is available. The fastest growing segment of S corporation taxpayers consists of relatively high net worth corporations, worth more than $10 million.
IRS claims that the study is to assist the Service with a “better understanding” of compliance concerns. Let me break that down for you: The IRS thinks that there’s some major cheating going on. Specifically, I believe that IRS is looking for potential violations with respect to the classification and payments of self-employment tax.
One of the most attractive features of the S corporation to many business owners (and their consultants) is the ability to “slice up” distributions to shareholders and reclassify those distributions. Traditionally, most compensation to shareholders who also served as owners was considered compensation and was taxable as ordinary income. As compensation for services, it was also subject to self-employment tax, which is the self-employed person’s version of FICA (your Social Security and Medicare contributions). The rate for self-employment tax is 15.3% of your wages; this tax is in addition to the actual income tax on those wages (which makes sense if you think about it since that’s what happens to folks who work for someone other than themselves).
And here is where the IRS becomes interested… Since 1984, there have been a number of tax packages passed that have increasingly made the notion of dividends more appealing – and none so much as the legislation passed under President Bush’s first term, which lowered rates. So practitioners started thinking… What IF you paid yourself a dividend instead of a salary? Traditionally, that’s not a good thing. But considering the “discount” of avoiding self-employment tax and the lower income tax rates, it can be considerable savings. Further, many people fervently believe that there will be no Social Security program for their own retirement, hence, why pay into the system? Is that true? And if so, does that make this practice cheating? You can imagine that where you fall on this side of the argument depends on who you are. The IRS is going to say yes, I believe. Practitioners and small business owners will say no.
I guess we’ll just have to watch this round of audits and see.
