Taxation & Estate Planning

AUDIT OPERATIONS AT THE IRS INCREASINGLY TARGET SMALL BUSINESSES

By Darrin Mish

If you are a taxpayer with a subchapter S corporation, partnership or a disregarded entity for taxation purposes watch out. The IRS intends to look more closely at entities that pass profits through to the owners who then report the profit or loss their personal tax returns. In these cases the return filed by the entity is purely "informational," showing only income, expenses and profit or loss. The entity is not required to pay taxes on any profit because the profit is then passed on to the entities partners or shareholders, who in turn pay any tax liability associated with the entity on their personal returns. A principal component in the reasoning behind more aggressive audits on these entities involves the question of whether or not, and if so to what degree should those profits be classified as a salary when the owners are self-employed.

The IRS views this as an opportunity to increase the collection of Social Security and Medicare taxes. In the past small business owners have been able to use these entities as tax savings tools by minimizing their personal salaries and classifying the remaining profits as distributions, thereby minimizing the amount of Social Security and Medicare taxes the had to pay. In recent years the IRS has taken the position that these type of entities must pay their owner/employees a salary corresponding with the fair market value of their service to the company. The Internal Revenue Code and the Treasury Regulations hold that as a matter of law officers and shareholders of these small businesses that perform services for the entities in question are employees. As employees they must be paid appropriately and their wages taxed accordingly, Social Security and Medicare taxes being withheld. U.S. Tax Courts have upheld the IRS's position on this matter and the underlying law.

Auditing operations at the IRS have been geared up to apply more concentrated focus on entities possessing a character that embodies potential abuse. Average CEO and corporate officer pay is in the high six and seven figures annually. It's going to be increasingly more difficult for a small business whose identity is closely linked with it's owner/employees (often just one or two individuals) to claim a small salary is fair market value when the company is showing sizable profits for the year. In many instances it will be easy for the IRS to make the case that the owner/employee IS the company, and therefore most if not all profit should be attributable to the services the owner/employee provides. With IRS collection efforts of recent years being focused toward payroll taxes, proper withholding and timely estimated payments, the additional burden placed on small business owners in the future as a result of this newly concentrated focus, is clearly foreseeable.

Full post as published by IRS Problem Solver Blog on July 30, 2008 (boomark / email).