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A batter who hits .320 is doing pretty well!

January 15, 2010

The Government Accountability Office reports that the recent "research project" exams found errors in 68% of S corporation returns examined. That compares to a 70% error rate in sole proprietorship returns. I didn't realize that 32% of 1120-S filings were "no activity" returns.

The IRS counted as "wrong" any return with an adjustment, no matter how minor. An experienced practitioner could make a change in just about any S corporation return with any substance, so it's not at all surprising. There are a lot of moving parts in a business return, and a lot of complicated tax provisions that apply. Consider the biggest "errors" in the returns:

By median misreported amount, noncompliance was the highest in not paying the correct wage compensation to S corporation shareholders; this noncompliance was much greater than the second highest median misreported amount—distributions to S corporation shareholders.

Begging the question: what is the "correct wage compensation" for an S corporation shareholder? The IRS wants S corporation compensation to be high to maximize FICA and Medicare tax receipts. In contrast, they want C corporation compensation to be low to maximize corporation taxable income and non-dedutible shareholder compensation. As the report admits:

Generally, an officer of an S corporation is considered to be an employee of the corporation for federal employment tax purposes, and thus employment taxes must be paid on an estimate of “reasonable” or adequate shareholder wage compensation. However, 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.

But let's say your S corporation is losing money. Should a 100% shareholder pay himself a "reasonable" salary just to ship some FICA money to the IRS? There would be no Self-employment tax liabilty for a similar Schedule C business, so that seems just stupid -- but the IRS is raising the issue on exams. And how can an S corporation owner know what salary is "reasonable" anyway? The owners and their preparers don't have some database they can plug into for, say, a "reasonable" salary for an owner of a struggling manufacturer in rural Iowa.

The "distribution" errors are directly the fault of IRS and Congress. The S corporation returns are poorly designed for determining the tax status of distributions, and the rules can be hard to understand. Tax prep software companies often do a nice job preparing off-to-the-side schedules of distribution taxability and shareholder basis. If the IRS wants to improve compliance there, they should redesign their K-1s based on what the software companies do.

Hat Tip: TaxProf Blog.

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