IRS gets upper hand in S corporation compensation audits

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Any compensation the owner receives is subject to FICA tax, which imposes an equivalent burden. And the IRS frequently attacks owners who receive cash distributions from an S corporation, arguing that the distributions were essentially disguised compensation. The IRS often wins those cases, in full or in part, and may collect penalties.

A previous post described that many taxpayers have turned to doing business as an S corporation. S corporation income is not subject to SE tax. That post described how a taxpayer failed to structure his business in a way that qualified for the S corporation exception to SE tax.

When taxpayers cannot reach agreement with the IRS, often they file a petition in Tax Court and negotiate with the IRS some more. Doing so lets them avoid paying tax until the dispute is finally resolved. However, recently the Tax Court decided that it could not hear certain disputes over whether distributions from S corporations should be reclassified as compensation subject to employment tax. In Program Manager Technical Assistance 2017-05, the IRS instructed examiners how to write up their audit findings so as to prevent taxpayers in such cases from going to Tax Court.
As a result of this development, taxpayers who cannot reach agreement with the IRS will need to pay the tax and sue for a refund, which most often is done in U.S District Court. Instead of hoping to put pressure on the IRS to settle for a lower amount while the case is in Tax Court, taxpayers may feel pressure to settle for a less favorable result when suing for a refund.

In many cases, it might make sense to start as an LLC that is disregarded for income tax purposes or taxed as a partnership, giving up on the SE issue when the business does not earn much more money than what would be reasonable compensation. When the LLC becomes more profitable, the owners can use a tax-free transaction to transfer the LLC to a limited partnership to save SE tax on income beyond amounts constituting reasonable compensation. The Tax Court can hear disputes over those reasonable compensation issues.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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