Discussion:S Corp Audit - Wages and Auto Expense

Thanks for the input!

Third post: "Although I should point out that distributions are actually less than the officers wages ($44k, $22k each)"

Something in your post is not right.

Owner and spouse distributed $27k in cash to themselves.

It appears that they each got 22k in wages and 13.5k in distributions. Intially this does not seem unreasonable, but like JR said it depends on many other issues as to whether it is reasonable or not. Some of the questions I asked are the same questions the IRS are going to want to know the answer to.

Add that concept to the debate on "reasonable" salary levels.

The audit issue is whether the amounts distributed should have been characterized as wages subject to FICA, FUTA, etc. The auditor is after the employment taxes, not the income tax.

There is a lot more involved in this flooring business than the personal services of the stockholder/officers. Presumably a substantial part of the corporation's net income is derived from the services of others (employees, contractors), sales of inventory, the use of capital equipment and facilities owned by the corporation, etc. As others have suggested, one way to attack the problem is to come up with a reasonable rate of return on those investments.

Rev Rul 74-44, 1974-1 CB 287

Radtke, Joseph v. U.S., (1990, CA7) 65 AFTR 2d 90-1155 , 895 F2d 1196 , 90-1 USTC ¶50113 , affg(1989, DC WI) 63 AFTR 2d 89-1469 , 712 F Supp 143 , 89-2 USTC ¶9466 .

Veterinary Surgical Consultants P.C., 117 TC 141, 10/15/2001

ESTATE OF WALLACE, 95 TC 525, 11/14/1990

Wiley L. Barron, CPA, Ltd., TC Summary Opinion 2001-10, 02/07/2001

Independent investor test, comparing wages paid to amounts paid for similar postions in other companies. Note Pegoo, you're not talking about CEO money here, rather what would it cost to hire someone to do the job you do? Not the owner stuff, the work stuff. Time spent by S/H in performing services. S/H's level of experience. Wages paid to other employees of the S. Overall income of the S. (that's a new one I've not seen...this is coming from the Taxbook quick summary) Wages paid in prior years. Comparison of wages paid to earnings and distributions (again, I've not seen that in the case law.)

Subsequent years here must be considered for pickup. It's in the IRM and in IRS' exam quality standards.

Corp and stockholders do not know exactly enough what the YE profit is going to be, or the cash flows needed to keep the doors open. The Corp must maintain adequate operating cash at levels to meet day to day expenses, as well as unexpected expense (give examples).

The agent is then going to say: "but the corp made distributios to shareholders, thus using up cash".

Reply: Yes, but the shareholders are willing and able to recontribute distributions (do not say as loans, unless the agent asks)in order to fund cash needs. The shareholders would be more reluctant to recontribute parts of their salary, which may have already been spent for personal needs.

JR1's point about pointing out the SS taxes being saved is a good one to keep in mind.

Presenting the issue in terms of - "If you're audited, the IRS will try to say that all distributions are wages, and you will owe x amount of ss additional ss taxes. So, what amount do you want to argue is a reasonable wage, and what will that figure be based on?"

Is this about what the rest of you do?

I feel kind of dumb, since in the last few years, I've been pushing C corporations to make the S election, so that they can eventually sell their businesses with less problems, and now I think I may have made them vulnerable to audit on the reasonable wage issue. Of course, those corporations are used to paying themselves large wages and never had thought of trying to play the Beat the FICA game.

A bit moot in this case, I think. $22K is not much of a full-time job doing anything, and whether laying floors or not, they also founded and manage a profitable business.

I have always felt Board of Directors meetings authorizing salary at the beginning of a year are a good idea. Everyone says they have little meaning to auditors, but many ask to see them. While I do few corporations now, I use to specify an upper limit on salary....e.g. in this case it might say not to exceed $30,000, e.g., and then give reasons that were discussed by the board members. You can all laugh, but it can a bargaining tool to prevent a greater conversion of distribution to salary.

1. Role in the company 2. External comparisons 3. Character and condition of the company 4. Conflict of interest 5. Internal consistency

Expect them to look at multiple years as they did in this case. In our defense, we cited Elliots V. Comm'r and the 5 factors, however, the comp. was larger than what you have for your specific situation. Another defense to support you distributions would be using a ROI factor. If your client has some equity w/i the business, and the distributions are lump sum even numbers, then you may be able to support them based on a Return on Investment Calcualtion. Our basis was that, owners of small companys, closely held, require a larger return on capital, and that depending on equity you could use that as defense of your distributions. Have all corporate minutes updated. They will ask. Review compensation for duties performed to determine market value. Maybe the wife worked partime, in which case a lower wage is warranted. Determine how much is at stake and negotiate. They will probably break it down on a per hour basis. Does your client have other employees working for them, and generating profit or flow thru. If you don't like the auditors reasoning for your challenges. Go to appeals. The auditors higher ups would not want them spending to much time on this audit, do to the cost /benefit and bigger fish to fry.

I wouldn't bank on that one. Relatively little time is required on the examiner's end for this issue, depending upon how little comp vs. distributions has been paid. The FICA deficiency is often much more than found in the usual income tax issues on most 1120-S of modest or smaller size.

Also, "bigger fish to fry" are not set aside to work small corps!

much time in this specific area where we had documented what reasonable comp. was relevant to market, how distributions were justified relevant to equity w/i the business, how officer was highest paid employee on payroll

Thanks again for the input.

PVVCPA - There were discussions about wage and auto. We talked about the shared roles of the taxpayer and spouse in the business. When said and done, the auditor agreed that they were essentailly two part timers, and that the wages were in fact reasonable. Auto was never a real big issue, as we had another outside of the corp. We took 100% for the corp auto, but I had thrown $1,000 back into other income on the corp return to cover any personal use that might have taken place. We had no issues with that....

When people are going to cheat on their taxes, they aren't going to do it by paying huge salaries out of their S-Corps.

P.S. Good job MNCPA!

I am currently auditing a S-Corp owner who has some loss, gain, loss years. His preparer missed a lot deductions, the taxpayer (TP) did not report 600,000 in gross receipts (and a corresponding amount of nearly $600,000 COGS), and no officer's comp. So what to do what to do.

Yes - a HUGE red flag is no officer's comp. Regarding the OP - if I ran across the $22k of officer's comp... whatever. I'd move along. There are bigger fish to fry besides someone who is paying a portion of the officer's comp. In addition, since they are already filing the 940's and 941's, that knocks out a lot of the penalty's bite! Yeah - definitely I'd ignore that stuff. An RA is not looking for a case with $5,000 in tax split up among 10 different filing requirements. We want 3+ years, related returns, $10k+ tax adjustments. That's an efficient use of government funds. At least that's how I roll. Thanks for the great read btw. Unless you piss them off, an auditor is not going to push an issue where the burden of proof is on the government when it will just go to appeals and be given away.

Thanks

(Office auditors generally sent out letters identifying specific line items they want to audit. Audit items are not "pre-selected" for field examiners. As they have much more latitude in selecting items, the procedure doesn't practically apply to them. However, as they don't want to invest time in no change audits, that doesn't mean that a field examiner won't "back off" an audit if the prior no-change on similar issues is pointed out to them.)

Thank-you for your imput. Must a RA put everything on an information document request in order to examine?

4.10.2.8.5 (08-01-2007)Repetitive Examinations

  1.If a taxpayer (individual) responds to the initial contact by stating that an examination of the same issue(s) in either of the two preceding years resulted in no-change or a small tax change (deficiency or overassessment), the following action will be taken:  1. Ask the taxpayer for information which may help to determine if repetitive examination procedures apply, such as the prior year(s) audit reports, where the return(s) were filed and where the examination(s) were completed.   2. If an appointment has been set, advise the taxpayer that the appointment is postponed pending a review of our files to determine if the examination should be continued.  3. Secure an IDRS command code I/BMFOLZ print of the taxpayer’s accounts. All individual returns closed as a no-change, require entry of an IMF no change issue code to allow AIMS to record the issues considered during the examination and no-changed. This print will display the no change issue(s). Classifiers will review this print if available during classification. See IRM 4.4.12 and visit http://wsep.ds.irsnet.gov/sites/co/dcse/sbse/exam/webdocuments/Document%20Library/1/AIMS/No%20Change%20Issue%20Codes%20-%20IMF%20Issue%20Codes.doc for a list of IMF Issue Codes.

  2. When the taxpayer provides records identifying the issues examined in prior years:  1. If the issues are the same as in the current year examination, and the I/BMFOLZ print indicates either no change or a small change to the taxpayer’s liability, then the current examination can be closed. Send Letter 2684 (DO) to close the examination.           2. If a substantive tax change is shown for either year, the taxpayer will be informed that repetitive audit procedures do not apply and the examination will be continued. Letter 2685 (DO), Repetitive Exam Letter, will be used to notify the taxpayer and reschedule the appointment.

  3. When the taxpayer does not furnish records to identify the issues examined in prior years, the examiner should pull a MFTRA and I/BMFOLZ print. The examiner should use the following techniques to determine whether repetitive audit procedures apply:
        1. If the MFTRA print indicates a no-change or small tax change for both years, or for one of the years and no examination activity for the other year and the no change issue codes on I/BMFOLZ print do not provide adequate information, then the return(s) and related files for the year(s) examined should be requisitioned. The requisitioned files should be reviewed to determine if the issues currently under examination are similar enough to the issues in the prior no change/small liability year(s) to warrant concluding the current examination.  2. If a substantive tax change is shown for either year the taxpayer will be informed that repetitive audit procedures do not apply and the examination will be continued. Letter 2685 (DO) will be used to notify the taxpayer and reschedule the appointment.

  4. In office examination, group manager approval must be obtained and documented on Form 9984-D before applying repetitive audit procedures. In field examination, managerial approval is not required on repetitive audit cases.

  5. Cases qualifying for repetitive audit should be closed as follows: 1. If the taxpayer’s records were not examined, even though contact was made, the case may be closed using "survey after assignment" procedures. See IRM 4.10.2.5.2.  2. If the taxpayer’s records were examined, the case will be closed using regular no-change procedures.

Source: http://www.irs.gov/irm/part4/irm_04-010-002r-cont01.html

IRM 4.10.2.5.2.2