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Richard Burt, CPA, LLC Accounting Firm, Debary, FL.

S-Corp. Tax Issues

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            Each year as we prepare tax returns (and we prepare a large number for S-corporations and their owners), we notice companies operating as an S-corporation exposing themselves unnecessarily to deduction disallowance or income inclusions by the IRS.  Here we will outline the most common problems, and easy steps to take to remedy the situation going forward.  If you recognize any of the following in your business, please take heed.

  • Taking “draws” whenever needed, without declaring them in the corporate records
  • Failing to take wages (payroll) when the company has some (even minor) taxable profits before “draws”
  • Lending or borrowing money without loan documents
  • Paying for vehicle fuel, insurance, etc. from the company account when a vehicle is personally owned.

            We will review each topic separately here, and explain where the exposure is and what can be done to minimize it.  First, many start-up S-corporation owners initially attempt to take money from the business by paying themselves a “draw”.  (The correct term is "distributions", however as "draw" is commonly used, we will intermingle the two terms here.)  The owners may believe that by doing so they are avoiding the hassle of payroll tax return filings and tax deposits.  If they had operated initially as a sole-proprietor, after all, this was a quite acceptable practice.  This, however, was because, as a sole-proprietor, ALL net profits were subjected to the 15.3% “Self-Employment” tax.  Now, however, as an S-corporation shareholder, such “draws” escape that 15.3% tax.  (Yet another justification to make all pay self-employment tax exempt “draws”, right?)

             While it may be a tax planning technique to reasonably maximize draws and minimize payroll, it must be done carefully and with adequate support, being certain a reasonable payroll is made before ANY draws are comntemplated.  The IRS is well aware of this technique, and has labeled it a “questionable practice” in its practitioner’s newsletter, particularly where done too agressively. 

             To be properly labeled a “draw” or “distribution”, several factors must be in place.  First, there must have been adequate compensation previously paid (i.e. payroll) to the owner for all services rendered.  What is “adequate”?  The IRS requires that owners be paid wages (requiring payroll tax filings) which are equivalent to what one would pay an unrelated party (and wages, of course, which that party would also deem adequate) to perform all of the services, including managerial and administrative, that are rendered.  If wages aren’t paid at all and the business has profits, there generally cannot be “draw” in the eyes of the IRS, unless the owner is totally separate from the business, rendering absolutely no services (i.e. purely as an investor and not involved in any business decisions or activities).

             Second, if there is more than one shareholder, you MUST make “draws” pro-rata overall.  That means if you pay a $400 distribution to a 40% shareholder, you must make a $600 distribution to the other 60% shareholder, assuming there are only two shareholders.

             Third, to pay “draw” or “distributions”, there should be a corporate meeting at which the directors/shareholders vote (and record that vote) to make a profit distribution to shareholders.  Note the distinction between “draw” and wages.  “Draw” properly reflects a distribution of excess profits after reasonable wages have been paid to all employees, including shareholder/owners.  “Draw” is not payment for services.

             This topic blends smoothly into the second topic – failure to take wages.  As noted above, the IRS looks for adequate wages to be paid.  In the S-corporation environment, they are always looking for under-compensation.  Should they find it, the tax consequences can be devastating.  Failure to file payroll tax returns and withhold and  pay payroll taxes can lead to significant penalties (in fact, it is the number one area in which penalties are assessed) and, coupled with interest over years of non-compliance, these assessments can easily put a company out of business.  Therefore, getting on track quickly is in your own best interest.       

             While complying with the payroll tax laws can be confusing, it is not difficult.  For most businesses, however, their time is better spent on their business itself, so the best way to comply, in my opinion, is to completely hand over the compliance to a competent CPA, bookkeeper or payroll company. 

             Tax professionals used to be divided on their opinion as to how aggressive the IRS would be in seeking out inadequate compensation.  Some believed they were blowing smoke, while others believed enforcement efforts would increase in this area.  There now is little doubt enforcement will increase. 

              In 2002 an internal IRS memo suggested that the IRS begin auditing all S-corporations which showed $10,000 or more in net profits, before “draws”, with no payroll to the owner providing services.  We have seen many actions indicating they have implemented that initiative.  Audits are increasingly resulting in taxation of up to 100% of “draws” by the IRS reclassifying them as wages.  Additionally, in July of 2010 an unemployment benefits extender bill included a provision to tax 100% of “draws” from certain small S-corporations (and LLC’s taxed as S-corporations) an extra 15.3% (recognize that number?) as a revenue raiser.  Fortunately, the provision was stripped from the bill before passage.  However we fully anticipate the issue to arise again, and probably in the not too distant future.

              Less recently, a court case was decided a few years ago (Nu-Look Design, Inc. v. Commissioner) in which the IRS successfully argued that “draws” of $10,866.14 in 1996, $14,216.37 in 1997, and $7,103.60 in 1998 were in fact disguised wages!  Note that here NO wages were paid, and small profits were “drawn”.  The danger in this case is, of course, that if adequate wages are not paid, it is entirely possible that ALL profits “drawn” may be reclassified as wages.

             The amazing thing here is that the IRS went after such a small taxpayer, for peanuts!  They incurred the cost (as did the losing taxpayer to fight it) to establish a legal precedent, which, of course, may now be used (and they have)against other mom and pop businesses. The old argument “I’m too small for them to go after” obviously no longer applies.

             Let’s now look at loans to or from the business.  Here again, the IRS likes to reclassify “loans” as taxable wages, or, in the case of loans to the company, (non-retrievable) capital contributions.  How do they get away with this?  Well, actually, it’s easy.  You see, all the IRS has to demonstrate is that you didn’t really treat it as a loan - that is to say you never drafted a legal loan document, never charged a fair interest rate, and/or never made regular payments against the “loan”.  Hence, you never really meant it to be a loan!  The easy way to prevent this type of problem is to draft a loan document, prepare a reasonable repayment schedule, including reasonable interest, and stick to it.  Then the IRS doesn’t have a leg to stand on!

             Finally, and widely prevalent, is reimbursing owners and employees for business expenses incurred by the individuals.  Frequent on this list is automobile mileage reimbursements, among others.  While there is nothing at all wrong about making such reimbursements, it is essential that proper tax protocol be followed to avoid having these reimbursements taxable as wages.  Generally, the IRS considers all payments made to employees to be wages.  Certain limited exceptions do apply, however, the most important of which may well be the Accountable Reimbursement Plan. 

             Unless the company has established an Accountable Reimbursement Plan in writing which meets several IRS requirements, reimbursements to employees or owners (over 2% S-corporation owners are deemed employees under tax law) are considered wages, subject to the normal payroll tax withholdings.  The resulting reimbursements are properly reported in Box 1 of Form W-2 along with normal wages.  However, for those companies which have adopted an Accountable Reimbursement Plan, these payments remain a tax deductible expense for the company, and are received totally tax-free by the employee.

             To be an Accountable Reimbursement Plan in the eyes of the IRS, the plan must be in writing, must require that proof of business expense be presented to (and retained by) the corporation within 60 days of the expenditure, and must require that any excess paid to the employee (i.e. in the form of an advance) must be returned to the company within 60 days.  Of course, the corporate minutes should reflect the authorization and adoption of the Accountable Reimbursement Plan.

             Often we see a small business using a personally owned vehicle for company business.  Many times, the company pays many of the vehicle expenses, often including fuel, insurance, loan payments, etc.  THESE PAYMENTS ARE WAGES, NOT REIMBURSEMENTS, as the company doesn’t own the vehicle, the individual does, and commonly no substantiation of the business use is properly recorded!  Each such payment is required to have taxes withheld, and be included in the employee’s W-2. 

             When reimbursement payments are made without having to account for the business use of the vehicle or other expenditure, it is referred to as a “non-accountable plan”.  Payments made from a non-accountable plan are includable in wages, subject to all normal withholding, and may be deductible on the owner/employee’s personal Form 1040, using Form 2106, to the limited extent allowable by law.  The easy solution here is to adopt the written plan and follow its requirements.

             Of course, one could put the vehicle in the company’s name.  The insurance premiums may rise, but if it is used 100% for business the company could pay all of the business expenses on its vehicle directly.  Any personal use would need to be reported on the owner/employee’s Form W-2 as wages, however.  Mileage records are required in either circumstance, so overall recordkeeping doesn’t change.

             As you can see, proper planning can allow favorable tax treatment or avoid unpleasant surprises upon IRS audit.  If you own an S-corporation, and want professional guidance and services, then Richard Burt, CPA, LLC is your logical choice.  Contact us today!

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