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The Online Advisor

October 2008


New Business
S corporations are now facing increased scrutiny from the IRS


According to the Journal of Accountancy, the S corporation is the most popular form of business ownership in the country, swelling to around four million entities. The primary reason for their growth is that S corporations avoid the double taxation that applies to regular C corporations while still offering protection from personal liability.

However, as the popularity of S corporations continues to rise, they are facing greater scrutiny from the IRS. In particular, the IRS has focused its attention on three issues.

* Shareholder-owner compensation. The basic tax rule is that compensation paid to shareholder-employees must be reasonable in amount. Historically, the IRS has questioned compensation amounts paid to C corporation owners that seemed unreasonably high. With an S corporation, a high-tax bracket owner may establish a compensation amount that is extremely low, or even zero, while increasing other pass-through income (i.e., dividends). By doing so, the owner avoids employment taxes on these payments.

The IRS recognizes the tax benefits of this strategy. Therefore, it may object to compensation that appears to be low relative to corporate profits.

Suggestion: Have compensation reviewed before the end of the year. If appropriate, the S corporation may pay bonuses to shareholder-employees. In any event, document the reasons for compensation amounts.

* Shareholder basis. Generally, a shareholder's "tax basis" for deducting corporate losses may be increased by contributing additional capital to the company, buying more stock, or lending funds to the company.

The IRS may challenge basis adjustments resulting from loans by third parties to the company. Furthermore, it has consistently maintained that a shareholder's guarantee of an S corporation debt does not increase basis.

Suggestion: Loans should be made directly from the shareholder to the S corporation. A written note, based on reasonable terms, can serve as proof that a bona fide loan exists.

* Fringe benefits. An S corporation may provide tax-free fringe benefits, like health insurance or employer-paid group-term life insurance coverage (up to $50,000), to its employees. However, if an employee owning 2% or more of the company receives fringe benefits, he or she is generally taxed on the value. To avoid abuses, the IRS may examine fringe benefit packages.

Note that there are several exceptions to the general rule. For example, certain "working condition" fringe benefits are tax-free to 2%-or-more shareholders.

Suggestion: Consider restricting benefits for owners to those that are essential or that result in minimal or no taxation.

In summary, S corporation owners must be careful to observe all the technicalities in the tax law. For assistance, contact our office.

Before you invest in any business, it's always a good idea to discuss the proposed venture with your advisors. If you would like assistance with evaluating a business opportunity or with legitimate tax planning, please call our office.

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