In a Nutshell

GKPC Alert: Non-Compliance with S Corporation Tax Rules

The United States Government Accountability Office issues extensive report to the U.S. Senate Finance Committee

What this Means for S Corps

The Internal Revenue Service's automated system for return selection will now accurately select S Corporation tax returns for correspondence audit and request basis calculations to support loss deductions. The existing selection system works very effectively for individual tax returns and will soon be enhanced to classify and select S Corporation returns. Lawmakers and the media have discussed legislation that would require employment taxes be applied to S Corporation profits. Discussions will continue, but legislation to change this tax treatment will not be passed in the foreseeable future.

Recommended Actions

Shareholder compensation. Review compensation levels for all shareholder/employees to confirm W-2 income reflects fair wages for the services provided based on education, time commitment, scope of responsibility, and authority.

Deduction of losses. Request a shareholder basis schedule be updated each year by the tax preparer. Understand the ramifications of loss deductions on taxation of future income, shareholder loan repayments, and non-deductible items.

Why the GAO Report Was issued

S Corporations are one of the fastest-growing business types, accounting for nearly 4 million businesses in 2006. A national research project completed by the Internal Revenue Service for tax years 2003 and 2004 examined 5,000 S Corporation returns. 68% of the returns examined misreported at least one item impacting net income. The General Accounting Office was asked to investigate and report on S Corporation compliance and recommendations for improving compliance.

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Significant Items of Non-compliance

Underreporting of wages paid to shareholder/employees and excess deduction of losses were common non-compliance problems.

Compensation to shareholder/employees is frequently misclassified as dividend distributions not subject to employment taxes or Federal income tax withholdings. Identifying and proving the magnitude of underreported wages is challenging, time-consuming, and difficult to quantify. Shareholder/employees will often underreport wages in an attempt to reduce tax liabilities. Other cases of underreported wages are due to misunderstanding of the tax law by both the shareholder/employee and the corporation's professional tax advisers.

Profits and losses flow from the S Corporation tax return to the shareholder's individual return. Determining the allowable loss deduction is a detailed, multi-step technical calculation. Losses are deducted on shareholder returns in error, as required calculations are prepared incorrectly or not prepared at all.

What Congress and the Internal Revenue Service May Do Next