IRS Targeting S Corporations in new Audit Program

The IRS has been targeting S corporations for many years, often to determine if the corporate shareholders are properly reporting all income on their personal tax returns. Many of these issues have related to the taxability of compensation and distributions from the corporation. Here are the issues the IRS will be reviewing during this new audit program:

  • Wages versus distributions. This is the classic issue of an S corporation shareholder wishing to take as much as possible in distributions to avoid the employment taxes (15.3%) on wages paid and received.
  • Taxability of distributions. Many S corporation distributions are tax free given that income taxes have already been paid in a prior year (the “phantom income” issue with flow-through business entities). It is therefore critical to keep excellent records of each shareholders’ basis in the company to make sure that additional taxes are not paid on the same income.
  • Tax issues with the S corporation itself when it makes a distribution of appreciated property to a shareholder (and fails to report the gain). A corporation can distribute property other than cash and this needs to be accounted for.
  • Tax issues for shareholders when distributions exceed their overall basis in the stock they own in the corporation. Again- basis issues are critical to reduce taxes.
  • Tax issues for determining if a distribution is properly classified as a dividend (and taxable) or a return of basis (not taxable) to the shareholder.

Even with this new audit (“compliance” as the IRS likes to call it!) program, S corporations are not audited with great frequency. Nevertheless, be aware of the tax rules and you will be prepared if your S corporation is called before the IRS to explain any of its transactions.