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S Corp Owners Beware! 3 Big Red Flags That Can Trigger an IRS Audit.

by Tracey Hrica, EA Dec 01, 2022 | Share

ATTENTION S CORP SHAREHOLDERS!!

Anyone remember when the Tax Cuts and Jobs Act(TCJA) was first enacted? Or, even know what it is, lol? If you don’t remember, it was the biggest rewrite of the tax code in decades.

One of the fallouts from the TCJA is the increased scrutiny by the IRS of S Corporations and their shareholders. 

The IRS has been especially interested in several tax liability issues regarding distributions, officer loan repayments, and, most of all, officer salaries.

The number one S Corp audit concern stems from net profits being paid out as distributions without reasonable salaries and associated Social Security and Medicare taxes.

Reasonable Salary

One of the requirements for an S Corporation shareholder is to take reasonable wages from their profitable business. By not doing so, you increase your chances of an audit.

If audited, the IRS can conclude that you have attempted to evade payroll taxes by disguising employee salaries as corporate distributions.

Remember, with an S Corporation, all business profits “pass-through” to the owners, who report them on their personal tax returns and pay tax on them at their individual tax rates.

The S Corporation itself does not pay any income tax.

If you remember, things changed when you formed an S Corporation. 

You’re no longer a simple business owner. Now, you’re the shareholder of the S Corp, and you’ll also be your company’s employee.

If this rule is not followed, the IRS can recharacterize your distributions as salary and require payment of employment taxes and penalties – payroll tax penalties of up to 100%, plus negligence penalties!

Another thing to remember about your salary as an S Corp shareholder is your health insurance premiums. 

Without the proper reporting, the S Corporation can lose the full deduction of these expenses.

For the S Corporation to take the full deduction, your W2 must include these premiums. If not, they are reported on your personal tax return BUT subject to considerable limitations.

You do not want to let this happen!

Distributions

Distributions from an S Corporation are NOT considered income as long as the distribution does not exceed the shareholder’s stock basis. 

Remember, the benefit of being taxed as an S Corporation is the Social Security and Medicare tax, or self-employment tax savings. This savings is possible because you are allowed to distribute profits to yourself as long as you have taken a reasonable salary like mentioned above, and have basis in the corporation.

However, without the proper amount of basis, excess distributions above your stock basis are taxed as capital gains on your personal tax return.

So, what is stock basis?

It’s the measure of investment made by each shareholder. 

To identify this amount, you must first begin calculating stock basis using the amount of money and property you contributed to the business when starting the S Corporation. 

Then, every year, you increase the basis by the corporate income reported on your taxes.

On the other hand, your basis in the company is decreased by your share of the business’s losses and the S Corporation’s nondeductible expenses.

Any additional funds that you transfer to the business will increase your basis; any distribution you receive from the S Corporation will decrease your basis.

Loan Repayments

Loans made to shareholders can be a particularly problematic issue with the IRS. 

If audited, unless the loan is documented and has repayment with interest, the loan can be reclassified as a distribution. Without the stock basis mentioned above, there will be capital gains.

Checkbox on Schedule E

S corporation shareholders should be aware of the checkbox on line 28 of the individual taxpayer return, Schedule E (Form 1040).

This box should be checked if you have reported a loss, have received a distribution, have disposed of stock, or have received a loan repayment from an S Corporation. 

In addition, you must attach documentation that details your S Corporation ownership basis.

As you can see, this can get a little complex, so make sure to consult with a tax professional.

Conclusion

As the IRS has been cracking down in these areas, it is imperative that S Corporation shareholders stay on top of these issues.

About the Author

Tracey Hrica, EA

Tracey Hrica joined the firm in 1995 as a bookkeeper. In 2012, she earned the designation of Enrolled Agent(EA), which enables her to prepare personal and business tax returns and represent clients before the IRS. To maintain the designation of EA, she must complete yearly continuing education in the areas of personal and business taxation. Working closely with her clients, Tracey’s primary areas of concentration are new client onboarding, client communication, research, and QuickBooks support. As a QuickBooks ProAdvisor, she works closely with clients who rely on QuickBooks for the day to day running of their business. Tracey has expertise in both QuickBooks Desktop and QuickBooks Online.

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