S corporations will be one of the major beneficiaries of the new tax law, the Tax Cuts and Jobs Act (“TCJA”), which added a new provision to the Internal Revenue Code. Owners of certain pass-through organizations can receive a 20% deduction on taxable income. But it’s not all good for S corporations who could face increased scrutiny from the IRS. Here’s why.
Let’s start with the basics. Pass-Through entities are those businesses that do not pay corporate income tax and include Sole Proprietorships, Partnerships, Limited Liability Corporations (“LLC”) and S corporations. Profits of these entities are passed directly through the business to the owners and are taxed on the owners’ individual income tax returns.
But owners of S corporations get compensated differently than the owners of other entities. S corporation owners receive W-2 compensation. The other owners have Earned Income from Self Employment.
Increased Tax Exposure
Therein lies their tax exposure. Here’s why. Many S corporation owners want to keep their W-2 income as low as possible to avoid payroll taxes. The IRS nows that too, and it’s on the top of their checklist when they show up to audit.
To prevent S corporations and their shareholders from avoiding payroll taxes by maximizing distributions and minimizing compensation payments, the IRS requires S corporations to pay shareholders who provide substantial services “Reasonable Compensation”.
But what exactly is Reasonable Compensation? It’s defined as “the value that would ordinarily be paid for like services by like enterprises under like circumstances”. In other words, it depends.
The IRS Spotlight on Reasonable Compensation
The IRS, of course, has some definite ideas on what constitutes Reasonable Compensation. Because of the TCJA, we anticipate the IRS will shine a spotlight on Reasonable Compensation for S corporation owners. Even before the new law, the IRS had already begun looking much more closely at S corporations and Reasonable Compensation. For example, the Austin, Texas IRS office has formed a task force focusing on Reasonable Compensation
On a national level, IRS audits are up 14% over last year and are expected to continue increasing. The IRS has systematically improved the methods for selecting S corporations for audit.
But according to a recent survey, only 12% of S corporation owners research and document how they reached their Reasonable Compensation figure. This means that the other 78% are at risk of having distributions reclassified as wages, if the IRS believes the wages paid were not reasonable for the services provided.
The High Cost of an IRS Reclassification
Business owners should be prepared to substantiate that their compensation is, in fact, Reasonable Compensation. Otherwise, the cost to the business owner – and his or her tax preparer – can be high.
- The total cost to the taxpayer is typically more than double the original tax that would have been due. The IRS average recommended adjustments have increased from $50,000 for tax years 2003-2004 to $105,000 for tax years 2007-2011.
- The tax preparer is subject to a penalty if she or she takes an unreasonable position on a tax return that results in an understatement of tax. The IRS has been handing out $5,000 penalties to preparers that signed a return that had an unreasonable low compensation figure.
Stress Testing for Reasonable Compensation
401(k) compliance reviews are gaining traction with employers as a risk management tool. It is, in fact, a stress test to determine the extent to which their 401(k) plans are exposed to IRS and Department of Labor examination problems.
A Reasonable Compensation Stress Test provides a similar form of protection. It’s a written report that synthesizes a proprietary blend of IRS criteria, Court Rulings, Bureau of Labor Statistics, U.S. Census data and a private database of wages to accurately assess and protect Reasonable Compensation risk for S corporation owners and their tax preparers.
Tax planning is done best in advance and proactively. S corporation owners and their tax preparers with Reasonable Compensation concerns should start stress testing early in the year – and certainly before they receive a letter from the IRS to schedule an audit.