S Corporation Under Audit

Kicking off The Tax TeleGraf's S Corporation Series is an informal case study of an IRS audit that involves… an S Corporation! What makes this case interesting is a "low" officer compensation and an overworked IRS Agent. I am fascinated by these types of cases because from a practical standpoint there seems to be a lot of open interpretation considered for the term "Reasonable Compensation."

Note: Information available from the Taxpayer was limited. This article is a high level overview of an IRS audit of an S Corporation. There are lots of resources from tax court cases and from the IRS itself on "Reasonable Compensation" that won't be discussed because it was written during tax season.

The Facts

Taxpayer solely owns a financial services business that he bought in 2009 but has been working for the business for 19 years. The company provides insurance, tax preparation (how ironic), and real estate services. There are three office locations with managers and staff that run the operations. The Taxpayer doesn't have to do much work in or on the business.

Tax years under audit were 2017 and 2018 for both personal and S Corp returns. In 2018, the Taxpayer paid himself a $75,000 salary and took out over $300,000 in distributions. The taxpayer's spouse was also taking a salary of $30,000 but performed no work for the business. The amount of net income for 2018 was never disclosed but we can probably assume it was over $300,000 based on the distributions.

The taxpayer's salary had been increasing over the years even though the amount of work in the business had decreased. The Taxpayer stated that he spent most of his time trading equities compared to time working on the business in 2018. During the audit the IRS Agent asked how many hours were worked in/on the business to substantiate the amount of trading activity.

According to the IRS Agent, the audit was random but the Taxpayer suspects a conservation easement triggered the audit. There had always been a high distribution to officer salary ratio since the purchase of the business in 2009 so we can probably assume that wasn't a trigger. The tax returns under audit were prepared by a CPA.

A $75,000 salary was chosen by the Taxpayer because $75,000 "is a salary that I could pay someone to come in off the street and do what I do." Who could argue against that reasoning?

The IRS Agent

The Taxpayer stated that his IRS Agent said they (the IRS) have him (the IRS Agent) doing 100 different things on top of the taxpayer's audit. After I heard that I stated "Makes me wonder if that makes an impact on how much the IRS Agent wants to try to argue anything against your position." The Taxpayer responded "That is 100% correct. Appeals department is currently understaffed as well." Enter Catch-22 reference.

The IRS Agent asked for physical receipts for specific expenses, looked through QuickBooks, and looked through bank statements.

While it appears that the IRS Agent was trying to get through this audit as quick as possible, we can't be for certain that the busyness of the IRS Agent had an influence on the end result.

The Findings

The IRS Agent found that two 1099s should have been filed by the S Corporation but let it slide. No change was made to either 2017 or 2018 S Corporation returns. For the Taxpayer's personal returns, the 2017 return required cryptocurrency reporting for some gains but no changes to 2018 return.

Thoughts

What seemed to be a glaring issue ended up being no issue at all and gives us some insight on what the IRS is looking for. I would expect the IRS Agent to question the salary of the Taxpayer more but the Agent seemed to be satisfied after the Taxpayer stated he could pay someone his salary to run the business. Was this because the Agent was so busy and the Appeals department had no capacity?

I do not believe this would be the case for every S Corporation audit. Each S Corp shareholder that provides more than minimal services to the S Corp is required to pay themselves a salary. The Tax Court (Mayson Manufacturing Co. v. Commissioner) has established nine factors to determine what that salary should be. The IRS has a 28 page  Reasonable Compensation Job Aid for IRS Valuation Professionals (Link).

This case seemed to have a simple application of what "Reasonable Compensation" is. Unfortunately, we cannot use this as status quo. I look forward to more cases like this to increase my understanding of S Corporations. Thanks for reading.