GAO S Corporation Report

The U.S. Government Accountability Office (GAO) recently released the report “Actions Need to Address Noncompliance with S Corporation Tax Rules.” The report included compilation of statistics on S corporation income tax returns, return preparation errors, and ideas on squeezing more payroll or self-employment taxes from S corporation shareholder-employees.

From tax year 2000 to 2006, the total number of S corporations increased 35% to almost 4 million. S corporations grew from 11.4% of all entities in tax year 2000 to 12.6% in tax year 2006. The S corporation is the most popular business entity. Although an S corporation can have up to 100 shareholders, in tax year 2006, 60% had just a single shareholder, 89% had two or fewer shareholders, and 94% had three or fewer shareholders.

Regarding the accuracy of S corporation tax return reporting, 68% of returns filed for tax years 2003 and 2004 (the years data were available) misreported at least one item. About 80% of the time the misreporting provided a tax advantage to the corporation and/or shareholder. Common reporting errors included shareholder distributions, personal expenses, and unsubstantiated deductions. The GAO estimated that 71% of S corporations that used a paid preparer for their returns were noncompliant.

The GAO estimated that 13% of S corporations paid shareholder wage / salary compensation that was not reasonable (too low), resulting in just over $23.6 billion in net underpaid wage compensation to shareholders. The median misreporting adjustment for underpaid shareholder compensation was $20,000. The GAO also found that the fewer the number of shareholders, the more likely an S corporation was to pay an unreasonable salary to a shareholder-employee.

The report recommended a number of tax law changes to mitigate the S corporation tax return errors, including subjecting to self-employment tax the entire net income of the S corporation, or of service sector S corporations, or income attributable to majority shareholders. Other alternatives include subjecting to payroll taxes not just shareholder wages but also distributions, or all payments up to a certain dollar amount.

These ideas have been kicked around for years, and although there is a threat that taxes may increase, there is no specific tax law change on the horizon that would hamper the huge self-employment / payroll tax savings that can be achieved through an S corporation.

S-Corporation Officer Reasonable Salary

IRS launches in February 2010 random employment tax audits. The goal of this Employment Tax National Research Project, the first in 25 years, is to figure out where the IRS can get the most money through audits. One key issue is S-Corporation owner / officer / shareholder reasonable compensation / salary / wages. The IRS loses huge amounts of money when S-Corporation owners take unreasonably low salaries, mainly due to loss of the 6.2% Social Security portion of the FICA tax. Social Security tax applies to the first $106,800 of salary but does not apply to S-corporation distributions / dividends.