Audits of “S” Corporations – Continued

In my last blog, I mentioned several ways that “S” corporations incorrectly report expenses on their tax return.  Let’s look a little more closely at these and see how these mistakes occur and why the IRS is targeting these mistakes.   The main reason, of course, is that these mistakes benefit the taxpayer 80% of the time!  Remember that I use the term corporation here to represent any kind of legal entity that files as an “S” corporation for tax purposes.

The first mistake I mentioned involves the deduction of ineligible expenses.   This usually occurs when the shareholder uses corporation money for personal expenses and then logs the expense as a corporate expense in his Profit and Loss statement, instead of logging it as a dividend or shareholder loan.  If this is done to any significant degree, it can put the corporation in a “paper loss” situation when, in reality, it is making a profit.  Careful tracking of every penny spent by the corporation can end these kind of mistakes.

The second mistake is the miscalculation of shareholder basis.  The basis of a shareholder in a corporation is a measure of how much that shareholder has invested in the corporation, whether in cash, equipment, services or otherwise.  The overvaluation of a shareholder’s basis can result in the shareholder reporting less profit on his personal income tax return and thus paying less tax.  The IRS tracks these kind of mistakes very closely.

The last mistake I mentioned was the payment of inadequate wages to a shareholder/employee.  A small corporation usually has only one or two shareholders and they almost always work for the corporation.  Some take no salary, only “draws” (dividends) as needed.  If the shareholder is working full time in the corporation, the IRS expects that person to take a salary so that payroll taxes and social security taxes are withheld on a regular basis.  Therefore most shareholders in that situation take a small salary to satisfy the IRS and take their dividends for the rest of their income.  This is advantageous to the corporation and the shareholder because the corporation does not have to pay the matching FICA tax on the dividends and the dividends are taxed differently to the shareholder.  It is legal to divide the income in this manner so long as the salary is not so small as to be totally out of proportion to that of other employees.