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.

S-Corporation Tax Court Case on Basis and Losses

In the tax court case Rodney Jordan v. Commissioner, shareholder loans were bona fide, as reported on the S-corporation tax return, but some repayments were taxable income because S-corporation tax losses had reduced the shareholder’s cost basis in the debt. It was also determined that the debt was open-account debt and that some S-corporation tax losses were disallowed for lack of basis.

LLC to S-Corporation Conversion Clarified

The IRS has issued a new ruling that applies to a Limited Liability Company (LLC) electing to be taxed as an S-corporation. The ruling clarifies that there does not need to be a short tax year as a C-corporation in the middle of the process of converting from a “partnership” (the default tax status of an LLC) to an S-corporation. Avoidance of the accounting and tax burdens of an intervening C-corporation tax year is welcome to all involved.

Small Business Tax Net Operating Loss Election Clarified

The IRS has issued clarification on the election to carry back a small business tax net operating (NOL) loss 3, 4, or 5 years. In this case the IRS has taken the pro-taxpayer interpretation regarding which years’ revenues are used to determine whether the loss is a qualifying small business tax NOL. The election may be made by filing the applicable refund claim forms, by attaching a statement to the tax return for the year in which the small business tax NOL arose.

S-Corporation Built-In Gains Period Now 7 Years

The new stimulus law, the American Recovery and Reinvestment Act of 2009, signed into law by President Obama on Feb. 17, temporarily reduced the S-Corporation built-in gains period from 10 to 7 years. For tax years 2009 and 2010, S-corporations can avoid C-corporation maximum-rate income tax on built-in gains. Built-in gains are generally gains that were unrealized at time of conversion from C-corporation to S-corporation. Generally these gains are subject to the maximum C-corporation tax rate if realized (the property is sold) by the S-corporation within 10 years of S-election.

Employee-Shareholder Reasonable Compensation

In addressing the issue of employee-shareholder reasonable compensation in the Menard Inc. tax court case, the Court of Appeals for the Seventh Circuit rejected the Tax Court's multi-factor approach in favor a single “independent investor” test. Under the independent investor test, if a hypothetical independent investor would consider the rate of return on his investment to be far higher than he had any reason to expect, the compensation paid is presumptively reasonable [regarding whether the compensation is unreasonably high, in the case of a C-corporation]. However, the presumption may be rebutted by evidence that the company's success was the result of extraneous factors, such as an unexpected discovery of oil under the company's land, or that the company intended to pay the owner/employee a disguised dividend rather than salary. Menard Inc. v Commissioner (CA 7 3/10/2009).

Real Estate Section 1031 Exchange QI Conversion

Conversion of Qualified Subchapter S-corporation Subsidiaries (QSSS or QSub) serving as real estate tax-deferred Section 1031 exchange Qualified Intermediary (QI) to C-corporations will not cause the corporations to be treated as new or different Section 1031 QI’s. Therefore, S-Corporation subsidiary conversion to C-Corporation will not cause pending real estate tax Section 1031 exchanges to fail. (PLR 200908005).

Longer Net Operating Loss Carry-Backs for Business Tax

The new tax law, the American Recovery and Reinvestment Act of 2009, allows small businesses that incur Net Operating Losses (NOL’s) in 2008 and later years to carry the loss back 2, 3, 4, or 5 years. Previously only a 2-year carry-back was allowed. For businesses that paid taxes in any of these years but incurred a loss in 2008, this carry-back can result in an immediate tax refund. The new rules apply to all small business tax returns, including S-Corporation tax returns, C-Corporation tax returns, Limited Liability Company (LLC) tax returns, partnership tax returns, and sole proprietorship / Schedule C tax returns. The rules also apply to losses from rental real estate.

American Recovery and Reinvestment Act of 2009

The new stimulus law extended to 2009 the 50% bonus depreciation and the Section 179 deduction limit of $250,000 -- big tax savings for business. Tax breaks for individuals include a refundable “making work pay” stimulus credit, enhanced child tax credit and earned income tax credit, an improved homebuyer credit, a new deduction for state sales and excise taxes paid on new vehicles, and a sweetened higher education credit. There's also a one-year AMT patch.

Late S-Corporation Election Allowed

IRS has again issued a Private Letter Ruling allowing a retroactive late S-corporation election when a corporation and its shareholders have reported income as if an S-Corporation election has been timely made, where reasonable cause was shown for failure to timely make the election. PLR 200904018.

S-Corporation Election Not Terminated by Convertible Debt

IRS privately ruled that an S-corporation that inadvertently created a second class of stock by issuing notes convertible into stock was allowed to continue as S-corporation as long as corrective adjustment were made.

Non-Resident Partners or Shareholders?

S-Corporations, partnerships, and LLC’s: March 16, 2009 is the Franchise Tax Board deadline for first-time filers and remitters of nonwage withholding for nonresidents to apply under the FTB's 2008 Nonresident Withholding Incentive Program and avoid penalties. Can send in past-due 2008 withholding as additional compensation on behalf of the nonresident payee and pay interest by March 16, 2009 and the FTB will waive some failure-to-file penalties and will not audit withholding for tax year 2007 and earlier.

S-Corporation Shareholder Reasonable Salary

Tax court case Beckley: S-corporation must properly document shareholder loans to avoid IRS challenge re: constructive dividends. This C-corp case can be applied to s-corporations with regard to salary instead of constructive dividends.

Year-End W-2 Reminders

Business Tax: Personal use of company-owned car should be added to each employee’s Form W-2, Wage & Tax Statement. Standard mileage rate not available for cars costing more than ~$15,000.

S-corporation: Shareholder’s health insurance premiums should be added to the shareholder’s Form W-2, Wage & Tax Statement. This income is not subject to FICA, and is then allowed as a deduction on the shareholder's income tax return (yes, it seems silly: the rules require you to add it to income and then turn around and deduct it).