IRS Red Flags to Avoid With Your S Corporation Tax Return | USTaxAid

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IRS Red Flags to Avoid With Your S Corporation Tax Return

Written by Diane Kennedy, CPA on March 13, 2012

Most S Corporation tax returns are due 3/15/12, with an extension possible for 6 months (to 9/15/12). There is an exception if you have an S Corporation that has a year-end that is something different then the calendar year-end of 12/31. In rare cases, the IRS has allowed S Corporations to use a different year-end, but it is necessary to file for their approval first.


A few more basics, and then we’ll get into the IRS red flags you want to avoid when you file your S Corporation return.
If you have an LLC (limited liability company) that has elected S Corporation treatment, it must follow the same tax rules as an S Corporation. The S Corporation is primarily a pass-through entity, which means the income and losses are reported on the shareholder’s personal tax return. There may be a state tax in some form, like with California’s $800 franchise tax, or the state may not even recognize the flow-through income status such as is the case with a Tennessee S corporation. Definitely, talk to a professional first and don’t assume that a blog entry or forum can give you all the information you need to make an important decision like finding the best entity.


Now that the warnings are all out of the way, let’s talk about some more things to watch out for. These are the things that the IRS uses to trigger audits.

There are three main issues right now: Basis, Salary/Distribution and Medical Insurance for shareholders.

  1. You must keep track of your basis in your company. It will be comprised of two parts: equity basis (how much you put in for stock and additional paid-in-capital) and debt basis (how much you loaned the company.) If you have losses in your company, the losses are allowed against your other income only as long as you have basis. In other words, no basis means no write-off.The IRS believes that most S Corporation owners aren’t tracking their basis and so they’re going to be asking many S Corporation shareholders to prove they have enough basis to substantiate the loss.Basis calculation is an accumulative process. In other words, if your S Corporation has been around for 5 years, you’ll need to show your calculation that includes the past 5 years.To get ready, start pulling your records together and ask your tax provider to help you prepare the correct supporting workpapers.
  2. Salary/DistributionAn S Corporation can pay you in two ways: salary and distribution. The salary is a deduction for the company (so it reduces the income that flows through to you) and it is subject to payroll tax. The distribution is what you take out of the company in cash and other assets. It does not change the taxable income of the company. And if you don’t take a distribution, you still may owe taxes because of taxable income.The distribution isn’t subject to payroll taxes.One tax-saving strategy is to reduce the amount of salary you take and increase the amount of distributions. That will save you payroll taxes. Then a few people got a little crazy with it and decided to have NO salary and the IRS stepped in.A surefire audit trigger is to have an S Corporation with income and no salary for the shareholders.Make sure your salary amount is reasonable for the work you do for the company.
  3. Medical InsuranceIf you’re a shareholder of an S Corporation, the corporation can not take a deduction for the medical insurance premiums paid on your behalf. Or if it does, you have to add it back into your income. You can, however, take a partial deduction for the medical insurance on your individual Form 1040 as “self-employed medical insurance.”I have no idea why the IRS made this so complicated!

The rules haven’t changed for S Corporations, but the IRS has gotten much better at spotting irregularities. And that means more audits.

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