We work diligently with our clients that have S entities to ensure that they receive reasonable compensation.  You do recall that pass-through companies like S entities must pay their principals ‘reasonable compensation’ (a salary commensurate with their experience, capabilities, and time worked).  In so doing, the rest of the profits of the firm can ‘pass-through’ to the principals, without being subject to employment (social security and Medicare) taxes,  a savings of some 15+% to augment the pass-through revenue.

To make it clear, I will include two examples.  In the first one, the firm paid its principal a reasonable salary, based upon the firm’s gross income, net profits, and the capabilities of the principal.

In the second one, no salary was paid to the principal.  Clearly that is not reasonable compensation.  In a normal situation (when the IRS was fully funded and had adequate personnel), all such firms would have its tax submission recomputed.  (Now, it’s a percentage– high, but not 100%.  You will find out in an upcoming blog why that percentage will once again approach 100%.)

Given that reasonable compensation was not proffered the principal, the IRS would allocate 100% of the pass-through income as compensation.  This would negate the pass-through income (as well as its 20% qualified business income [of $400K] which would not be subject to personal income taxes), impose social security and Medicare taxes of some $ 25K, and a accuracy penalty of at least $ 25K.  So, besides this $ 50K of additional payments required, the principal would also owe income taxes on the $ 400K of QBI that was previously allowed, adding some $140K to the total.

Now, that’s what would happen in a perfect world.

But…

This isn’t a perfect world.

The GOP has been starving the IRS for more than a decade.  First, because it felt that they were being persecuted by the IRS’ review of their “non-profit” political committees.  That the IRS felt these were an abuse of the system.  (Just so you know, the IRS did the SAME investigations of those Democratic Party jiggered political action committees.)

Then, recently, when an increase in the IRS funding was proposed to let it more adequately investigate corporate tax abuse and finagling by the richer folks of our society, the GOP refused to approve the funds.  Because they didn’t want the IRS to bother the rich or the corporate class.  (Yes, they actually said that.)

So, it’s not surprising that TIGTA (Treasury Inspector General for Tax Administration) released a report outlining the failure of the IRS to adequately enforce the law when it comes to S corporation compensation.  (You know, the failure to pay principals ‘reasonable compensation’.)  And, we are not talking about chicken feed- TIGTA has discerned we are talking about billions of dollars these folks cheated off their taxes due.

Less than 1% of the S corporations are examined for compliance with employment taxes.  (That’s separate from examining for reasonable compensation).  And, when an S corporation’s tax return is under review, less than half the IRS agents examine if reasonable compensation was paid to the principals, letting these firms take tax-free distributions in lieu of compensation.

(Note that the TIGTA report limited its examination to S corporation returns with profits exceeding $ 100K, had a single shareholder- AND HAD NO COMPENSATION LISTED ON LINE 7 [compensation of officers] for tax years 2016 through 2018.  There were more than 266K returns that were not so examined; the profits from these entities exceeded $ 100 billion- with almost $ 70 billion taken in pass-through distributions.  TIGTA estimated that at least $ 25 billion in compensation should have been paid- which would yield at least $3.3 billion in Social Security and Medicare taxes.  [You know the funds that the GOP always claim are running out of money.  Gee, I wonder why!]  TIGTA didn’t try to compute how much more in taxes the principals would owe in income taxes on that compensation- or the loss of the 20% QBI on that income that is provided tax-free to the principals.)

The report also touched on another big problem.  One that I didn’t realize that wasn’t on the IRS radar.  They found more than 150 S corporations (and 424 returns) that had non-resident aliens as shareholders.  What’s that?  It is illegal for non-resident aliens to be shareholders of S corporations.  The IRS should have relegated those business entities as C corporations (no pass-through income allowed), and assessed some $ 5 million in income taxes upon the C corporations.

It’s way past time to adequately fund the IRS.  To go after the tax cheats- those that don’t get paid solely by W2’s and 1099’s.

Trust me- that’s coming soon.  (First in a blog post, and then to reality.)