According to a recent report, the IRS has overlooked substantial tax amounts that S-corporation executives should have claimed on their income tax forms and paid taxes on. Those amounts, which add up to billions of dollars, should have been rightfully declared and added to the government’s coffers to help pay for social security and other things. Since the IRS has overlooked these undeclared salary amounts, they are essentially sending a message to the rest of society, particularly those working for S-corporations, that it’s somehow acceptable to not declare and pay taxes on the money that you make. This problem has deeper implications as well, especially when it comes to how these executives essentially got away with it.
What Is an S-Corporation?
In order to understand the full-reaching implications of the issue, as well as grasp just how these corporations and business executives got away with not paying taxes on their income, it’s necessary to know exactly what an S-corporation is and how it works.
Of course, it helps to understand what a traditional C-corporation is as well, so you can tell the differences between them. After all, a C-corporation is what most people think of when they hear the word “corporation.” A C-corporation is a standard business that pays income taxes to the federal government as an organization. In addition, their employees at all levels pay income taxes on their salaries.
An S-corporation is different in that it doesn’t pay those corporate income taxes. Instead, the business is owned by shareholders who declare any company losses or income on their own individual tax returns. In essence, they are paying the individual taxes for the business, making it clear that the executives who did not declare these amounts on their taxes (and which were not followed up on by the IRS) managed to get away with essentially making tax-free money. However, this is not how S-corporations are supposed to work.
Thankfully, not every company is eligible to be designated as an S-corporation. In order to become one, the business must file incorporation papers as an S-corporation at the state level. The company also needs to have less than 100 shareholders, all of whom must be individuals, although some exceptions are made for trusts and similarly structured organizations. In addition, all of the shareholders need to be residents or citizens of the United States, and only regular common stock is available for them to own in the company.
Now that you know exactly what an S-corporation is, it’s time to go over some of the issues that come along with the IRS overlooking this particular group of taxpayers.
How The IRS Overlooked S-Corporation Executive Compensation
Every year, the IRS selects a number of tax returns for an audit. The percentages pulled from various demographic groups, as far as income is concerned, varies, depending on a number of different factors. However, last year, the IRS only pulled 1% of S-corporation returns (even though the company does not pay income taxes, they must still submit a tax return) for an audit. This is a very small percentage of the overall S-corporations in the United States, leaving many businesses unaudited.
To further compound issues, the IRS agents who completed the audits on S-corporation returns did not look into the compensation reported by the company. There are one of two different avenues that this could go down, so to speak. One, that the S-corporation reported compensation accurately, yet the executives who received that compensation failed to declare it on their tax returns, thus getting away with it. Or, two, the S-corporation did not report compensation accurately, meaning that the issue was dropped right away, as the agents did not explore this avenue of inaccuracy.
In some cases, the executives in question could have received a tax-free distribution from the business instead of receiving their standard compensation, and the IRS would never know. The executive who did not report this compensation on his or her individual tax return essentially received a tax-free payment from the business, as the IRS did not look into the issue.
How the Tax Cuts and Jobs Act of 2017 Plays a Role in This Situation
Although the Tax Cuts and Jobs Act of 2017 was intended to help the economy by providing tax cuts to businesses, so they could hire more workers, it actually wound up creating a loophole that businesses and their executives could use to avoid paying taxes on their compensation – by having no traditional “compensation” at all.
Thanks to a provision in the Act, executives of corporations, particularly S-corporations, could opt to receive a share of the company’s profits instead of getting a traditional salary. This share of the profits, which is received as cash, is then either not accurately claimed on the executive’s tax return or is taxed at a lower rate. The Tax Cuts and Jobs Act of 2017 set the tax rate for profits at 29.6%, as opposed to the tax rate for executive salaries, which is 37%, not including the rate of Medicare taxes that is added on top of that amount.
It is clear that these executives are exploiting this loophole and then not including their compensatory S-corporation profits on their tax returns. Since the IRS is not pulling these returns for audits, and when they do, they overlook compensation, the executives are not paying the right amount of taxes, leaving the government short billions of dollars.
An Examination of the Records
An independent organization pulled S-corporation tax returns from the span of several years, ranging from 2016 to 2018. After examining them carefully, they reported results that show just where the IRS has gone wrong by not auditing these companies more closely. For example, those returns, about 266,095 of them, were not put under additional scrutiny by having undergone a field examination by IRS agents. This allowed their shareholders to not pay their fair share of taxes.
Out of those 266,095 tax returns, the independent analysis found that companies with a single shareholder (that could also be considered a sole proprietorship) made profit amounts of more than 108 billion dollars. Those same single shareholders received 69 billion dollars from their companies, which they took as a share of the profits rather than straight compensation. Had they declared these amounts on their individual returns, they would have been taxed at the lower rate of 29.6% instead of the standard 37%, exploiting the loophole explained above. By reporting their compensation incorrectly, they did not pay the FICA, social security, and Medicare taxes that they should have. And since the IRS did not catch this problem, those shareholders were not penalized for paying an incorrect amount in taxes or for incorrectly reporting their income.
In all, the analysis showed that the problem led to 3.3 billion dollars in FICA taxes that should have been paid on almost 25 million dollars of improperly reported income. As you can see, this is an issue that the IRS should pay more attention to on a yearly basis.
Having Non-Resident Aliens as Business Owners and Shareholders
Another issue brought up by the experts involves having non-resident aliens in the roles of business owners and shareholders for the S-corporations. Since this is something that would force the companies to change their designation, making them become a C-corporation instead, it exacerbates the problems raised by the IRS overlooking these tax returns.
The main difference here is that C-corporations must pay corporate income taxes, and S-corporations do not. S-corporations that have non-resident aliens in these important roles are operating incorrectly, and their owners and shareholders have found a loophole of sorts that allows them to not pay the taxes that they should be paying, since non-resident aliens, in most cases, do not file U.S. income tax returns. By exploiting the fact that the IRS does not look for these issues by conducting audits on a greater percentage of S-corporation tax returns, they are turning a blind eye to the problem and allowing billions of dollars fall through the cracks.
The IRS’ Response
In light of this information, the IRS agreed that they should do something about these non-compliant S-corporations having non-resident aliens as business owners and shareholders, and they put a plan into place regarding them. However, they currently have no plans to change their auditing process.
Contact Us Today
If you have received a salary from an S-corporation and failed to declare the amount on your taxes, it’s not too late to file an amended return and pay the IRS what you owe. Please reach out to the tax advisors at Enterprise Consultants Group. We can answer your questions, discuss your rights, and provide actionable options. Please contact us online or at (800) 575-9284 today to schedule a free and confidential consultation to see how we can help you.
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