Monday, January 25, 2010

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.