S-corp and audit

[BHoffman]

This begs another question:

What if the shareholder takes monthly distributions through the year, but has no idea whether he will have profit by the end of the year?

If profit exists at year end, is it acceptable to recharacterize the distributions as salary by treating them like "employee advances" against one year-end "bonus" paycheck?

For example: (for simplicity sake, let's just assume FICA only)

Total distributions taken through the year - $10,000

One paycheck issued at 12/31 for gross wages of $10,765.

FICA withheld - (765)

Net check - $10,000.

The net check amount would be credited against the prior distributions taken during the year instead of Cash.

Would the IRS look at monthly distributions and want to recharacterize them as salary and impose late filing and late payment penalties? Or, would they accept the year end bonus as satisifying the officer salary requirement as long as the payroll taxes were remitted for the year?

On the other hand:

What if the shareholder ends the year with a loss, but has still taken distributions? As far as I know, if there is a loss then no salary is required as the cash would come from "borrowed" funds, like a business loan or accounts payable, or previously taxed income, like contributed capital.

[AuditorTurnedGood]

[QUOTE=JG EA;88341]I do yell at my clients at any given point in the year when they don't have enough money at that time to give themselves a payroll check but have the money to take a distribution.QUOTE]

Good to know I'm not the only one who yells.

ATG

[JG EA]

Well, a PSC isn't exactly what we're discussing, with it's disgusting 35% tax bracket on the corp level (shiver), because as you point out, an S-corp is de facto not a PSC. If the S-Corp owner/officer does't have a significant capital investment in the business, the business doesn't have significant assets, and there is no "human capital" in the business, I think it stands to reason that the efforts of the S-Corp officer are what create the profits, mostly because there are no assets to leverage to create profit, and that compensation for services provided is the definition of salary.

As a service based business, with most of my s-corp clients in the same boat, am I forcing through 100% of profit as salary? No. In my case, could the IRS easily reclass my distributions to salary and make the above argument? I have no employees, very little invested, and virtually no assets, so I think if they wanted to swat at flys with Scudd missles, they could make a pretty good argument for it. And I'd appeal.

I shouldn't have confused my point and brought up PSC.

My point was just that personal service isn't a factor for S-Corps in the rules right now as far as anything I've read. (Unless they don't take reasonable compensation.)

I do yell at my clients at any given point in the year when they don't have enough money at that time to give themselves a payroll check but have the money to take a distribution. I think in that case the IRS could justify changing it into payroll. They then have to make up later so that at the end of the year (ideally each quarter) they have enough in payroll. I had a client give himself a bonus in a prior quarter that didn't come through as payroll and I made him redo everything (I did the work) and change it into payroll. They way I looked at it - he called it a bonus - plenty of profit - so that seemed best to me.

[AuditorTurnedGood]

OK actually you make a point that is on the minds of lawmakers, but "personal service" corporation is not a designation for an S-Corp. Do you not agree that the rules at this time do not put on these requirements?

Well, a PSC isn't exactly what we're discussing, with it's disgusting 35% tax bracket on the corp level (shiver), because as you point out, an S-corp is de facto not a PSC. If the S-Corp owner/officer does't have a significant capital investment in the business, the business doesn't have significant assets, and there is no "human capital" in the business, I think it stands to reason that the efforts of the S-Corp officer are what create the profits, mostly because there are no assets to leverage to create profit, and that compensation for services provided is the definition of salary.

As a service based business, with most of my s-corp clients in the same boat, am I forcing through 100% of profit as salary? No. In my case, could the IRS easily reclass my distributions to salary and make the above argument? I have no employees, very little invested, and virtually no assets, so I think if they wanted to swat at flys with Scudd missles, they could make a pretty good argument for it. And I'd appeal.

[ChEAr$]

OK actually you make a point that is on the minds of lawmakers, but "personal service" corporation is not a designation for an S-Corp. Do you not agree that the rules at this time do not put on these requirements?

Note, that ATG used the term "personal service business", and not personal service corporation, which we all know doesn't relate to an S corp.

[JG EA]

Agreed. But, in a personal service business, are those assets actually producing income? The income itself is produced by the efforts of the employee. (BTW, I'm not on the side of this being the right answer, just one possibility to keep in mind). Let's remember that "reasonable compensation" is nearly as well defined as "realistic possibility"

OK actually you make a point that is on the minds of lawmakers, but "personal service" corporation is not a designation for an S-Corp. Do you not agree that the rules at this time do not put on these requirements?

[AuditorTurnedGood]

...You still have goodwill and investments in office and office equipment.

Agreed. But, in a personal service business, are those assets actually producing income? The income itself is produced by the efforts of the employee. (BTW, I'm not on the side of this being the right answer, just one possibility to keep in mind). Let's remember that "reasonable compensation" is nearly as well defined as "realistic possibility"

[Gretel]

...because you could hire someone to do the work and only that salary would be subject to payroll taxes. You still have goodwill and investments in office and office equipment.

[AuditorTurnedGood]

I don't think that is true at this time. Although as has been pointed out it may be true for everyone soon. But it is a corporation and the only requirement at this time is "reasonable compensation" not whether you do all the work yourself.

I think the IRS actually would have a good argument to make it all salary. If you think about salary itself, it is paid to an employee to compensate for their time and efforts. If all of the profits of the company are created by the time spent by the employee/owner, and there are no assets to speak of or other employees that do any of the work, (or creating any of the profits), why wouldn't it all be salary?

[JG EA]

...
in Case #2, there is only labor involved, and negligible expenses.
Reasonable salary for this fellow would certainly be closer to profits, since it's all
his own labor intensive, and similar to personal service income. The fact he only
puts in average of 20 hours a week is immaterial. IRS would go after the whole
enchilada.

I don't think that is true at this time. Although as has been pointed out it may be true for everyone soon. But it is a corporation and the only requirement at this time is "reasonable compensation" not whether you do all the work yourself.

[Gretel]

In a recent seminar I heard that going through a questionnaire available at www.payscale.com and then print it out for the records will stand up in an audit. I think this is what the IRS uses also.

[ChEAr$]

I believe the red light might flash but the client will be protected from audit changes if they pay themselves reasonable salaries. I use sites like salary.com or others to try and determine what is reasonable.

I wish there were more "hard and fast" rules regarding this issue.

What do you all think of the following?:

Profits at $40k. Drawings at $25k. Salary.com says reasonable salary is $50k. What amount do you think this shareholder should receive in salary? I've read elsewhere that the IRS probably won't insist to see more than the amount of drawings as salary if profits are lower than reasonable salary, but believe that is just someone else's opinion. Like very much to know more about that.

Or the reverse -

Profits at $300k. Drawings at $250k. Salary.com says reasonable salary ranges $80k - $100k. He's (say) a web designer. He works from home and has no overhead or employees. He puts in 20 hours a week. What would reasonable salary be for this fellow?

Thanks for your time in considering these issues.

It's all facts and circumstances, a phrase we all know and love.

However the term we use is distributions, not drawings. but anyway.

Case # 1:Salary.com may be a reasonable starting point of course, but any salary
before profits more than profits, is way too much. Factor in also in all cases, a
suitable return on investment (ROI) and the intangible factor of goodwill.

This case, assuming it is a well established business, salary of $20,000 might be
reasonable. This case differs from # 2 in that

in Case #2, there is only labor involved, and negligible expenses.
Reasonable salary for this fellow would certainly be closer to profits, since it's all
his own labor intensive, and similar to personal service income. The fact he only
puts in average of 20 hours a week is immaterial. IRS would go after the whole
enchilada.

[JON]

You may not

have to worry about reasonable comp in an S corp after 2009. The head of the House Ways and Means has his bill taxing for SE purposes all UTI to stockholders who are also employees of the company. The IRS had the 2003 audit sample of S corps and then the 2005 audit sample. They seemed to conclude that the number of S Coprs had grown enormously from 1998 forward and they believed one of the main reasons was the advantage of controlling the FICA wages. Remember the IRS really does not want to audit for SE changes, but the white papers they wrote after the two times they sampled pretty much said this area was being abused and should be changed. The Social Security Admin then took the numbers and came up with they could have collected and then the political part started. It was already in his 2007 bill that he did not submit- politics.

If a sole proprietor manufacturer reports on a a 1040 Schedule C he pays SE on all his earnings. Why should the choice of an operating enity make a difference to how much goes to Social Security? That was his comment.

[BHoffman]

Would like your opinions

I believe the red light might flash but the client will be protected from audit changes if they pay themselves reasonable salaries. I use sites like salary.com or others to try and determine what is reasonable.

I wish there were more "hard and fast" rules regarding this issue.

What do you all think of the following?:

Profits at $40k. Drawings at $25k. Salary.com says reasonable salary is $50k. What amount do you think this shareholder should receive in salary? I've read elsewhere that the IRS probably won't insist to see more than the amount of drawings as salary if profits are lower than reasonable salary, but believe that is just someone else's opinion. Like very much to know more about that.

Or the reverse -

Profits at $300k. Drawings at $250k. Salary.com says reasonable salary ranges $80k - $100k. He's (say) a web designer. He works from home and has no overhead or employees. He puts in 20 hours a week. What would reasonable salary be for this fellow?

Thanks for your time in considering these issues.

[S T]

No recent reference

I have heard the IRS is conducting a comprehensive program to audit every single S-corp due to the SE tax on dividend and W-2 wages issue.

I searched my IRS Quick Alerts, and NAEA and a couple of other sources that I receive, and I can not locate any recent reference (last few months) to accelerating the audits of S Corps (every S Corp return)

However, I do believe the program in the past has been successful, and IRS and/or States will continue to look at S Corps, if there is an absence of "reasonable compensation" reported for shareholders on a W-2 and if distributions are "too high"

Sandy