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May 2011 IRS Increases Scrutiny of S Corporations Seeking to enhance federal revenues and close loopholes, the IRS takes a closer look at tax issues pertaining to S corporation shareholders’ tax basis and compensation The IRS reports that, in ranking the selection of various forms of business entity, S corporations are second in popularity only to sole proprietorships. This popularity hasn’t gone unnoticed in Washington. In recent years, the federal government has looked for better ways to audit S corporations and to enforce compliance with various tax requirements. A recent General Accounting Office (GAO) report focused on three primary issues arising from IRS compliance audits:
The first item is one that can come up on audits of any type of business; the second and third are more relevant to S corporation returns and, thus, are the focus of this article. Calculating Shareholder Basis Determining a shareholder’s basis is important for three reasons: It limits the amount of corporate loss that shareholders can deduct; it helps to determine the amount of gain or loss when stock of an S corporation is sold; and it sets the upper limit for the amount of tax-free distributions that a shareholder can receive from the corporation. Determining a shareholder’s initial basis in S corporation stock depends on how the shares were acquired, i.e., via purchase, gift, inheritance, initial formation, conversion from C to S status, or stock for services. Purchase. When shares are legitimately purchased, the cost of those shares forms the initial basis.
Gift. Generally, gifted stock will take the
donor’s basis. However, when the fair market value (FMV) is less than its basis
at the time of the gift, the recipient’s basis for determining a loss is the
property’s FMV, while its basis for determining a gain is the donor’s basis. The
initial basis for determining the deductibility of current and carryover losses
is the stock’s FMV at the date of gift. Initial Formation. The basis is generally equal to the basis of cash or other property transferred to the corporation, minus the value of property received from the corporation, plus any gain recognized on the transfer. Conversion from C to S Status. The initial basis equals the shareholder’s basis in C stock at the time of conversion. Stock for Services. Basis in stock received in exchange for services depends on the stock’s FMV and the value of the services for which the stock was exchanged. Annual Adjustments. Shareholders adjust their stock basis every year by various items of corporate income, loss and deduction, and by distributions they receive. Stock basis is, first, increased by the stockholder's share of income and gain items, certain depletion, and certain additions to an asset’s basis due to general business credit recapture; second, decreased by distributions that are treated as a tax-free return of basis; and, finally, decreased by the stockholder’s share of loss and deduction items, nondeductible corporate expenses, certain depletion, and certain decreases to an asset’s basis due to general business credits. If a shareholder sells, gifts or otherwise disposes of stock during the corporation's tax year, adjustments to the basis are generally effective immediately before the stock is disposed of. Basis from Debt. S corporation shareholders obtain basis from debts that are owed by the corporation directly to the shareholders, including loans that are made during the corporation’s current tax year. That's good news, because shareholders can deduct losses against debt basis after their stock basis has been reduced to zero. The same pass-through items of loss and deduction that affect stock basis are used to reduce debt basis. However, distributions do not reduce debt basis. Shareholder loans should be properly documented and bear an interest rate that is at least equal to the Applicable Federal Rate of interest (AFR). Doing this helps avoid the risk that the debt might be considered as a second class of stock and, thus, terminate the corporation's status as an S corporation. Corporate income items generally increase stock basis. However, income items first increase debt basis (up to the balance of the loan determined at the beginning of the tax year) to the extent debt basis has been reduced by post-1982 losses. The IRS has consistently maintained that a debt must be owed directly by the S corporation to the shareholder before the shareholder obtains any basis. A shareholder acting as a guarantor, co-maker or surety for a corporation's loan from a third party (e.g., a bank) does not provide debt basis to the shareholder. Keeping track of a shareholder's basis in an S corporation can be complex but is more manageable if the basis is updated annually, which is a service Schmidt Westergard provides whenever possible for our annual S corporation tax clients. Shareholder-Employee Compensation In contrast to a C corporation (where there is an incentive to maximize shareholder compensation and, thus, minimize dividends), S corporation shareholders are typically challenged for paying too little, if any, compensation, in order to reduce employment taxes.
According to the GAO report cited earlier, 13% of S
corporations surveyed paid their actively involved shareholders wages that were
deemed to be inadequate (either too little or none at all). What Is Reasonable? Knowing when compensation is reasonable is elusive, because reasonableness is a function of circumstances that vary with the company and its industry. However, in most situations a range of reasonable compensation can be determined. The better the documentation and the greater the business reasons for the payments by the S corporation, the more likely that the compensation will withstand IRS attack. IRS Fact Sheet FS-2008-25 covers some of the factors that courts have considered in determining reasonableness:
Courts have also considered such compensation factors as (a) the company’s character, size, complexity and financial condition; (b) general economic conditions; (c) salaries paid versus sales, net income, shareholder distributions and retained earnings; (d) the shareholder’s individual salary history, including the corporation’s internal consistency in establishing the shareholder’s salary; (e) conflicts of interest in setting compensation levels; (f) corporate intent in making the payments; (g) whether the shareholder guaranteed the corporation’s debt; and (h) whether a hypothetical investor would conclude that there is an adequate return on investment after considering the shareholder’s compensation. Examiner Attitudes. A GAO survey of IRS examiners revealed that reasonable compensation is so open to interpretation and debate that examiners tend to pursue the issue only in the most egregious cases, i.e., where the shareholders were paid little or no wages but received large distributions – especially in service sector businesses and where the actively employed shareholder is also a majority shareholder. Setting Compensation. For S corporation shareholders who want to minimize payroll taxes, it’s okay to be a bit aggressive, but paying little or no compensation in a situation where the shareholder is clearly providing substantial services to the corporation will prove very difficult to defend. In the event of an IRS challenge, it is very important that documentation exists showing how the corporation determined that the compensation paid is reasonable. Absent more concrete methods of determining reasonableness, having that determination on file can go a long way toward defending the reasonableness of shareholder compensation. Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market. |
