Attention All You S Corporation Owners

Our friends at the Internal Revenue Service have found that out of all corporate income tax returns filed in the United State, 57% are filed as Subchapter S corporations. Because of this statistic, a compliance check of these entities is underway with a selection to be made nationwide of 5,000 returns. From this sampling, IRS will determine the level of compliance with issues governing S corporations and will expand audits based on its findings. The time has come to make sure your entity is in compliance.

What is a Subchapter S corporation? The basic explanation of this entity is to describe it as a corporation formed to limit exposure of its owner or owners to liability. Unlike the regular corporation, The S corporation is typically not a taxable entity in and of it self with its earnings flowing through to its shareholder or shareholders. The beauty of this flow through is that it is not subject to self-employment taxes which has become one of the major attractions of electing S corporation status. The typical S corporation will normally prevent a charge of unreasonable compensation being raised by the IRS which can create a definate hardship for regular corporations (C corporations). S corporations can not pay fringe benefits to its more than 2% owners of the stock of the entity and have them be deducted at the entity level. Now that we have the basic ground work for the characteristics of the S corporation, let's discuss what the IRS might be trying to find.

First of all, my thought is that the flow through of S corporation earnings will be a major focus. Though S corporation shareholders enjoy flow through earnings not being subject to the self-employment tax, I think this enjoyment gets a bit out of hand when profits are all taken as S distributions. My friends, there must be W-2 compensation to the shareholder group as atleat one is performing a service to the corporation. If the business is just beginning, there is an argument to say that year one will not provide any compensation to the shareholder group as what ever is earned will be needed to fund operations. In this event, there should be minimal S distributions to the shareholders and better still, there could be a small salary paid to the person operating the entity. These considerations should be spelled out in the corporate minutes. As time goes on and the earnings history is improved, it makes sense to increase shareholder compensation to atleast the maximum salary limit for social security. If there is a retirment plan in the S corporation, salary can be set to take advantage of retirement contributions (S earnings do not count as earned income for purposes of taking retirement benefits). If there is a group of shareholders not participating in the S corporation's day to day operations, they will not need to receive W-2 compensation. However, there relationship to the entity should be explained in the minutes of the corporation or in a contract.

The other issue to be careful of is the fringe benefit area. I wonder if the IRS's search will find that more than 2% shareholders of S corporations are taking deductible fringes at the corporate level in vilolation of tax law? Health insurance wouldn't be my worry as S shareholders are now permitted to take 100% of health insurance premiums paid by the corporation. I am more concerned about long-term care premiums, child care benefits, medical reimbursements, and the like. These items must be included in the W-2's of the shareholders receiving benefits as opposed to the non shareholder employees receiving the same benefits.

The last major item that I beleive will be an issue is in the area of built-in gains. What is this built-in gains issue? If the entity was operating a a C corporation previously and wished to make a subchapter S election going forward, the assets of the C corporation must be valued as of the first day the S election becomes in effect. This is telling the IRS the fair market value of assets and liabilites as of the S election date to begin the 10 year clock on built -in gain recognition. If the S corporation sells its built-in gain assets during this ten-year time period, it will be forced to pay corporate level income tax at the top corporate income tax rate. How many of these situations have been executed properly? Were the assets properly valued? Was the right allocation made to the asset classes of the corporation? Is the shareholder group aware of the ten-year time frame? In many instances, I have found that the assets were not properly valued is at all and the shoreholder groups seemed surprised by the ten-year time period. If your C corporation is planning to make this entity switch, please make sure that the assets are valued by a capable business valuation expert and that a capbale CPA works along side this person. Doing this right is a major issue in many instances involving serious income tax dollars.

In closing, the Internal Revenue Service is looking carefully into the filings of S corporations and it may time for your entity to get a check up.