S Corporation Audits Coming Soon

[JCH]

Thats an extra 80,000, not 5,000. The 5,000 are already finished. IRS had so much fun doing those, they now want 80,000 more.

And very few random audits are ever done anymore. They will use their computers to pick out 1120S returns with low wages reported on line 7.

This is interesting, if it's true. I've heard the rumor many times before about the stepup in S corp audits, but haven't actually read this anywhere before. What or who is the source for this supposed increase in audits? I haven't read this in the Kiplinger Tax Letter or anywhere else for that matter, so I'm curious.

[ED SMITH]

Good Odds!

Eighty thousand's a lot, but out of 3 million, it's still not bad odds.

The odds are about 40 to 1 or 2.5%, which is less than Sch C audits.

[Black Bart]

You know,

...They will use their computers to pick out 1120S returns with low wages reported on line 7.

if they pick returns solely on the basis of line 7, then the odds, although still favorable, aren't quite so good.

I figure that at least half the S corps are lowballing wages and avoiding FICA (the main reason for doing one). But if the other half are organized for liability protection only, are unconcerned with FICA,, and show a decent line 7, then the 80K will be picked out of only 1.5M returns. The risk would be doubled (one out of 20 instead of one out of 40).

Dennis! How can I make a "frown" face?

[Bees Knees]

This is interesting, if it's true. I've heard the rumor many times before about the stepup in S corp audits, but haven't actually read this anywhere before. What or who is the source for this supposed increase in audits? I haven't read this in the Kiplinger Tax Letter or anywhere else for that matter, so I'm curious.

If you do a Google search on S corporation IRS audits, you will get plenty of hits for the preliminary 5,000 S corporation audits that have been going on the past few years. They all talk about this as a test case, which gives IRS statistical data to train their auditors on issues they should be looking for when doing an S corporation audit.

I was at a tax seminar sponsored by the Minnesota CPA Society last Friday in Bloomington MN. The speaker was Bob Jennings, http://www.taxspeaker.com/ a CPA from Clarksville, IN. Many folks remember him back in the days when he spoke for a popular national seminar company, before it was bought by a huge foreign conglomerate.

Bob has extensive audit experience, and is asked to speak on occasion at training seminars for IRS employees. He knows many higher ups at the IRS. I didn’t write down the guys name, but one of the decision makers at IRS told him IRS was gearing up to conduct 80,000 S corporation audits. IRS auditors are currently being trained how to conduct S corporation audits using the data gathered by the 5,000 test audits, and the number one issue they will look at is shareholder/employee wages. If you don’t believe what he says, you can send him an email and ask how he knows this to be true (there is a place to do that from his website). He says he answers every email.

[Bees Knees]

And the correct answer is….

As is the case with all battles fought in court, there are always a number of issues that determine the outcome.

TTB, page 18-11 discusses shareholder wages in the context of a C corporation. In our example of a $100,000 pre W-2 profit, the shareholder wants to avoid double taxation, thus, will pay a wage equal to or close to $100,000. TTB says:

“Courts consider facts and circumstances in judging what is reasonable
with particular emphasis on the amount an unrelated
party would be paid for the same work in a different company.
Other factors include wages paid compared to dividends, economic
condition of the company, under-compensation in prior
years, and timing of the distributions.”

TTB, page 19-11 discusses shareholder wages in the context of an S corporation. In our example of a $100,000 pre W-2 profit, the shareholder wants to avoid FICA tax, thus, will pay a wage as low as possible. TTB says:

“The following factors are often cited in court cases in relation to determining reasonable wages for an S corporation shareholder.
• The “independent investor test,” comparing wages paid to the amount paid for similar positions in other companies.
• The time spent by the shareholder in performing services.
• The shareholder’s level of experience.
• Wages paid to other employees of the S corporation.
• Overall income of the S corporation.
• Wages paid in prior years.
• Comparison of wages paid to earnings and distributions.”

In both the C corporation reasonable comp issue where IRS says the wage was too high, and the S corporation reasonable comp issues where IRS says the wage was too low, the courts consider a number of factors. The most common factor in all court cases is considering the amount it would take to hire an unrelated employee to do all the work the shareholder does for his corporation.”

In our example of an auto mechanic making $100,000 prior to paying himself a wage, an S corporation should justify his wage by considering the amount it would take to hire an employee to do the same thing. In Becker Minnesota, an auto mechanic III position according to http://www.salary.com/personal/layou...nl_default.asp will pay on average somewhere between $41,695 and $53,295, an auto mechanic ll position will pay on average somewhere between $34,902 and $44,609, and an auto mechanic l position will pay on average between $26,246 and $34,921. Since we are talking about the S corporation shareholder who is also managing the business, I would tend to take the wage on the higher end.

In other words, I believe I could justify my S corporation shareholder auto mechanic taking a $50,000 per year salary, and taking the other $50,000 out as a distribution. An IRS auditor may try to argue otherwise, but nobody in appeals is going to take it to court when you base it on a study of how much other people earn as employees doing similar work.

[dsi]

I don't think any of my current s-corp clients have anything to worry about. However, I do know a few s-corp S/H's here in town who take very unreasonable wages, anywhere from $0 to $20,000 for the entire year, while their distributions are between $15,000 to $80,000 respectfully.

These are the s-corps I believe will be audited, and rightfully so.

[dsi]

[JCH]

If you do a Google search on S corporation IRS audits, you will get plenty of hits for the preliminary 5,000 S corporation audits that have been going on the past few years. They all talk about this as a test case, which gives IRS statistical data to train their auditors on issues they should be looking for when doing an S corporation audit.

I was at a tax seminar sponsored by the Minnesota CPA Society last Friday in Bloomington MN. The speaker was Bob Jennings, http://www.taxspeaker.com/ a CPA from Clarksville, IN. Many folks remember him back in the days when he spoke for a popular national seminar company, before it was bought by a huge foreign conglomerate.

Bob has extensive audit experience, and is asked to speak on occasion at training seminars for IRS employees. He knows many higher ups at the IRS. I didn’t write down the guys name, but one of the decision makers at IRS told him IRS was gearing up to conduct 80,000 S corporation audits. IRS auditors are currently being trained how to conduct S corporation audits using the data gathered by the 5,000 test audits, and the number one issue they will look at is shareholder/employee wages. If you don’t believe what he says, you can send him an email and ask how he knows this to be true (there is a place to do that from his website). He says he answers every email.

Yes, the 5,000 audits are fact. I think we're all in agreement on that. I'm familiar with the speaker, and remember him from the Gear Up days. However, I do question the 80,000 figure. I question if the Service has the resources to audit that many SCorps, and I also think that Jennings has a bit of sensationalism in his presentation style which probably serves him well as a paid speaker.

I guess time will tell if this is really true.

[sea-tax]

>Bees:In our example of an auto mechanic making $100,000 prior to paying himself a wage, an S corporation should justify his wage by considering the amount it would take to hire an employee to do the same thing. In Becker Minnesota, an auto mechanic III position according to http://www.salary.com/personal/layou...nl_default.asp will pay on average somewhere between $41,695 and $53,295, an auto mechanic ll position will pay on average somewhere between $34,902 and $44,609, and an auto mechanic l position will pay on average between $26,246 and $34,921. Since we are talking about the S corporation shareholder who is also managing the business, I would tend to take the wage on the higher end.<

From the people I have talked to who have had to deal with the IRS on this vary issue it has not been this simple.

In one example that I eluded to yesterday a friend of mine had a comp audit for a client who was taking what they thought was reasonable salary something in the neighborhood of 35 or 40k, if memory serves it was a gas station or something similar. Then took another 40k in distributions. The auditor inquired about the past life prior to owning a business. the client worked for Boeing back then making approx 80k the auditor said that 80k then is reasonable. Her reason was that 80k is what he needed to live off of and she saw no relavant issue with someone taking lower pay to work for themselves. My friend said he showed her the statistics of what a gas / convience attendandt makes, she did not care.
This is only one auditor and it may be an unusal situation but none the less it still happened and it is kind of scary that the IRS is operating like this.

[Bees Knees]

In one example that I eluded to yesterday a friend of mine had a comp audit for a client who was taking what they thought was reasonable salary something in the neighborhood of 35 or 40k, if memory serves it was a gas station or something similar. Then took another 40k in distributions. The auditor inquired about the past life prior to owning a business. the client worked for Boeing back then making approx 80k the auditor said that 80k then is reasonable. Her reason was that 80k is what he needed to live off of and she saw no relavant issue with someone taking lower pay to work for themselves. My friend said he showed her the statistics of what a gas / convience attendandt makes, she did not care.
This is only one auditor and it may be an unusal situation but none the less it still happened and it is kind of scary that the IRS is operating like this.

And of course the auditor is going to take that position. Take it to appeals, and no appeals officer is going to force the issue in court IF you have a reasonable study of what other people in the same line of work make as employees. THAT is what the courts have consistently looked at over everything else.

We as practitioners need to take a solid stand against the IRS auditors when they decide start making up rules. The FACT of the matter is court cases have many times shot down IRS arguments based on the silly notion that a gas station owner ought to pull the same salary he had when he was a Boeing Rocket Scientist. No court is going to agree with that. Who says you have to make the same salary as a business owner than when you worked as an employee?

Any self employed people out there agree with that?

[sea-tax]

Bees I agree with you that in an appeals or court this won't hold up, however most small businesses either don't want the headache or don't have the money to go all the way to court to plead their case. I think the IRS knows this fact is is therefore palying a little loose with the law so to speak.

[Bees Knees]

Yes, the 5,000 audits are fact. I think we're all in agreement on that. I'm familiar with the speaker, and remember him from the Gear Up days. However, I do question the 80,000 figure. I question if the Service has the resources to audit that many SCorps, and I also think that Jennings has a bit of sensationalism in his presentation style which probably serves him well as a paid speaker.

He also questioned whether IRS could conduct that many audits. However, the category of audit also includes automated letters generated by their computer matching system. All they have to do is send you a letter saying your line 7 wages are too low and ask you to justify it. Then pick from those who fail to give a reasonable response.

As to his sensationalism, at least he has a passion for the information he presents, which is more than I can say for many boring speakers I've heard over the years.

[BOB W]

Let's suppose that a low wages for the officer/shareholder is based on hours contributed to the business. Will that change how the net profit is taxed? In relation to passive vs non-passive income.

[Bees Knees]

Let's suppose that a low wages for the officer/shareholder is based on hours contributed to the business. Will that change how the net profit is taxed? In relation to passive vs non-passive income.

I would think that would be a difficult case to make for our single shareholder no other employee corporation. Under the material participation rules, it is deemed non-passive under test 2 (TTB page 7-11) where it says:

“2) The individual’s participation in the activity for the tax year constitutes substantially all of the participation in the activity of all individuals for the year, including the participation of individuals who did not have any ownership interest in the activity,”

That could mean a low hour W-2 wage by the shareholder that only represents 20 hours of work per year is still a non-passive activity if nobody else ever puts in more hours. It could work, however, if the owner actual does hire other employees to do most if not all of the work.

[BOB W]

I should of stated that there are other employees that take care of operations.

Adding to this list of reasons why there are low wages should make a good discussion for this thread. Things like return on investment or a high inventory businesses.

Can anyone else think of other "excuses"................?????????