How To Start And Run Your Own Corporation: S-Corporations For Small Business Owners.
How To Start And Run Your Own Corporation
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How to Start And Run Your Own Corporation: S-Corporations For Small Business Owners?

2010 GAO Report Examines S Corporations

In 2010, the United States Government Accountability Office (GAO) issued a report to the U.S. Senate Finance Committee titled "TAX GAP: Actions Needed to Address Noncompliance with S Corporation Tax Rules." The report examined how well S-corporations and their shareholders accurately reported income and expenses. The study also addressed the difficulty shareholders have in understanding and calculating shareholder basis. Finally, the report examined employee salaries paid to shareholders and how Social Security and Medicare taxes are affected by allowing S corporations to treat only a portion of withdrawn income as salary.

Using IRS data, it was estimated that 68 percent of S corporations misreported at least one item on their tax return. The report concluded 75 percent of S corporations not using a paid tax preparer were noncompliant. The professional tax preparers didn't do much better: 71 percent of their tax returns were found to be noncompliant. Single shareholder corporations had the most instances of misreporting. For example, 72 percent of single shareholder corporations misreported income; 30 percent misreported distributions; and 57 percent misreported other deductions.

The report didn't examine whether the misreporting was primarily intentional or accidental, but most "errors" led to shareholders paying less. One relatively small study found the most common type of misreporting was improperly deducting personal expenses as business expenses. The second most common type of misreporting on S corporation tax returns was not adequately substantiating expenses.

Nearly four million businesses operated as S corporations in 2006. Those businesses had $3.3 trillion in total assets and $413 billion in total net income. S corporations have grown slightly as a percentage of all businesses, representing nearly 13 percent of all companies by 2006. S corporations are the second most popular business structure, exceeded only by sole proprietorships (which includes some Limited Liability Companies or LLCs, which are treated as a disregarded entity for tax purposes and often operate as sole proprietorships or partnerships from a tax standpoint).

Most S corporations had only a few shareholders. The report said in 2006, 60 percent of S corporations had one shareholder; 89 percent had two or fewer shareholders; and 94 percent had three or fewer shareholders. Single owner S corporations accounted for 30% of all the income and deductions reported by S corporations. The ability to pass business losses through to shareholders and being able to calculate employment taxes on wages rather than on net business income were the most significant tax-related reasons business owners operated as S corporations.

Despite the large number of reporting errors, the study said: "In fiscal year 2008, IRS examined over 16,000 S corporation returns, which equates to less than 0.5 percent of all S corporations filing tax returns." The IRS is relatively understaffed to perform more audits. No doubt a few more auditors could earn their keep examining S corporation tax returns.

The report estimated 13 percent of S corporations paid inadequate salaries to officer/shareholders in 2003 and 2004. This represented nearly $24 billion in underreported wages or nearly $4 billion in uncollected Social Security and Medicare taxes. The study states: "…the difficulty and subjectivity in determining what constitutes an adequate wage enables some S corporations to pay inadequate wage compensation for the labor provided and compensate their officers through higher amounts of distributions, payments of personal expenses, and/or loans."

While it is legitimate to pay a reasonable wage to shareholder/officers who work for the corporation and to allow employment-tax-free distributions beyond a reasonable wage, the study makes several possible recommendations that, if implemented, could adversely affect even those S corporations who pay reasonable wages.

One recommendation the study proposed was to make net business income subject to employment taxation. This would tax small S corporations much like sole proprietorships with regard to employment taxes. One estimate said this could raise $57 billion in Social Security and Medicare tax revenue over 10 years.

The study also recommended making payments to active shareholders subject to employment tax. Profits retained within the company for growth wouldn't incur employment taxation. But all distributions would be classified as salary and be subject to employment taxation.

Clearly, the GAO is looking for simple ways to boost the amount S corporations and their shareholders pay in Social Security and Medicare taxes. It's not how clear whether Congress would implement such a recommendation. The study said S corporation shareholders opposed such changes. They'd rather pay less in employment taxes and have the option of receiving employment-tax-free distributions above a reasonable wage. Shareholders also argued they should be able to receive loans from their corporations, which should not be subject to employment tax, providing the loan was legitimate and the shareholder intended to repay the loan.

In a tough recession, employment taxes take a sizeable bite out of the modest earnings of many S corporations because officers must remove those earnings as wages to support their families. For example, if a struggling single-shareholder S corporation earns only $20,000 and if that shareholder/officer isn't independently wealthy, she might need to pay it all as salary and incur the maximum level of employment taxation to be compliant with IRS reasonable-wage rules. While helping the important goal of funding retirements, this makes small company survival more difficult.

Because Social Security benefits are partly determined by the level of wages, I'd like to see officers of S corporations be allowed to opt out of Social Security. This option could also be extended to sole proprietors. Rather than have subjective uncertainty about what is considered a reasonable wage and expect the IRS to look at wages on a case-by-case basis to determine if they're reasonable, simply allow shareholder/owners the option to set their level of salary income and choose how much of it is subject to Social Security taxation. Leave this decision in the hands of the entrepreneurs.

For most retirees, Social Security has proven to be a crucial program, so I'm not saying it's in the best interests of entrepreneurs to opt out of Social Security if they were given the option. I'm simply saying it would be nice for entrepreneurs who operate S corporations to be able to choose their wage level without worrying about subjective reasonableness requirements. This would provide the companies more flexibility to survive a serious recession.

Because everybody benefits from Medicare and usually participates in it regardless of salary, all distributions to active shareholders could be subjected to Medicare taxation. To me, at least, allowing entrepreneurs to choose their wages without concern about reasonableness requirements coupled with a full Medicare tax on all distributions seems a fair compromise. This, however, was not one of the GAO's recommendations.

The GAO recommend Congress should require S corporations to calculate and report basis for their shareholders’ ownership shares. The report observed: "Shareholders are responsible for calculating and tracking basis. While the Schedule K-1 sent to shareholders lists some information that can be used to calculate basis, S corporations are not required to report any basis calculations to shareholders. The only information on how to calculate stock basis is on the Schedule K-1 instructions."

The report concluded: "IRS officials as well as stakeholder representatives said that calculating and tracking basis was one of the biggest challenges for shareholders." Basically, if you're confused about basis, you're not alone. The report recommended the IRS provide more guidance in understanding and calculating shareholder basis. The report also noted the IRS doesn't provide a publication specifically written for S corporations. It only provides instructions for the basic S corporation tax return, the 1120S. In contrast, there is a special publication to help sole proprietors understand Schedule C and sole proprietor tax reporting. Adding a specialty tax publication for S corporations is something I've recommended for a decade. That would help honest entrepreneurs do a better job understanding and reporting their S-corporation taxes.

Basis is important because it determines the extent to which S-corporation losses can be used to offset income from other sources. As with misreported deductions, the report didn't distinguish between corporations that simply didn't understand basis and made unintentional errors and those companies which were intentionally taking deductions which they knew they were disallowed.

For tax buffs who aren't IRS insiders, the report provided a bit of insight in how the IRS does its job. For example, we learn about the yK1 software, sort of a big brother for taxpayers which helps ferret out fraud.

The report explains:

"One way that examiners detect S corporation noncompliance is IRS’s yK1 software program, which uses Schedule K-1 information to graphically depict relationships among taxpaying entities. It displays the shareholders of S corporations as well as any other businesses that are linked to the S corporation, including parent companies and subsidiaries that have common shareholders with the S corporation. Starting with a business entity or individual shareholder, yK1 can show its connections in sending or receiving Schedule K-1s. It shows common use of paid preparers, some family relationships (e.g., husband/wife), and common addresses, among other linkages. For example, if IRS discovers noncompliance that is related to a scheme marketed by a preparer, IRS can use yK1 to identify other entities that used the same preparer. In addition to K-1 data, IRS pulls data from various IRS databases, such as those showing data from filed returns or from information returns filed by third parties. Although there have been no formal analyses of yK1’s effectiveness, IRS officials say that its examiners report that using yK1 has helped to identify millions of dollars in unpaid taxes from entities, including S corporations. For S corporations, yK1 data can help examiners determine if the shareholder has stock or debt basis, as well as establish trends in officer’s compensation."

The report also suggested the possible regulation of paid S-corporation tax preparers. The report observed:

"The accuracy of S corporation returns might be improved through the regulation of paid preparers, such as legislation that requires preparers who work on S corporation returns to be licensed. We reported in 200835 that federal individual tax returns filed by taxpayers in Oregon, which has a rigorous preparer licensing requirement, were more likely to be accurate compared to those filed by taxpayers in the rest of the country. Preparers in Oregon have to pass an open book examination to receive their licenses to practice, and about 68 percent of the people taking the examination passed."

The extent to which Congress or the IRS adopts the changes proposed by the GAO is uncertain. The Report is GAO-10-195, Noncompliance with S Corporation Tax Rules.

Peter Hupalo, author of
How to Start And Run Your Own Corporation: S-Corporations For Small Business Owners