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On August 11, 2011, TIGTA published a report entitled ‘”Efforts to Address the Compliance Risk of Underreporting of S Corporation Officers' Compensation are Increasing, but More Action Can Be Taken.” At the outset, TIGTA properly identified part of the problem: there are S corporations – some owned by one individual and others owned by groups – where the officers perform work and do not pay themselves compensation.
The S corporation is a “pass through,” so that its income would be passed through and be reported by the Officer. However, this technique has the effect of depriving the Government of employment taxes which would be payable in the event that the amounts withdrawn were taken as compensation. The TIGTA Report comes up with an astronomical number of allegedly unreported and unpaid employment taxes as a result of this approach.
There are a number of institutional problems that give rise to this situation, and TIGTA misses the boat when it simply criticizes the failure of Income Tax Examiners to raise the issue in their cases. What TIGTA ignores is the fact that the Internal Revenue Service, which has an incredible job trying to apply the Internal Revenue Code of 1986 as Amended, has chosen to split up its Examination functions into a Group for income taxes which is the group that examines S corporations, and one for employment taxes.
The Agents that are trained in issues relating to businesses’ income and expenses are not equipped to make an independent determination of what “reasonable” compensation would be, as Internal Revenue Code Section 162 only allows deductions for reasonable compensation. The Courts have over the years struggled to find a good yardstick for determining what reasonable compensation in any particular situation would be. It is not a “one-size-fits-all” approach, although as discussed below, the employment tax side of the Internal Revenue Service Examination Function seems to think it is. The point in a nutshell is that the Income Tax Examiners have enough on their hands trying to deal with items of income and expense without having to also make the determinations of what reasonable compensation should be when it has not been deducted.
When one walks over to the Employment Tax Group approach, the rule is pretty close to “shoot first and ask questions later.” The experience of this writer is that when that Group does an examination of an S corporation (or for that matter a C corporation), any and all distributions to the Shareholders are deemed to be unreported compensation, even if the Shareholder is already taking and reporting compensation. There is no effort whatsoever to determine what “reasonable” compensation is. In fact, the results often create situations where the amount of deemed compensation exceeds what would be allowable in an income tax audit for “reasonable compensation.” These are situations where an S corporation must basically “grin and bear it” until the examination is over, and then take the matter to the IRS Appeals Office or to the United States Tax Court. There are, in addition to people who make a living analyzing compensation, public statistics which could be used if only the Employment Tax Group bothered to consult them. Doing a compensation analysis is apparently not part of their job.
The reality is that the Income Tax Examiners are not cross-trained in employment tax issues, and the Employment Tax Examiners are not cross-trained in income tax matters and issues. The world might be better if it were possible to have “one-stop shopping” and such issues could be considered by just one Examiner at a time, but the Code is unfairly complex. Thus, that is not the way the system works. As usual, TIGTA has not come up with a way to provide funding that would be required for the additional training of either the Employment Tax or Income Tax Examiners to meet its standards.
23 years ago, the United States Congress passed the IRS Restructuring and Reform Act of 1998, which served to level the playing field in IRS collection matters and other procedural areas. Perhaps it is time for a “TIGTA Restructuring and Reform Act,” so that this part of the Treasury will stop just taking cheap shots about areas in which it either does not have knowledge or is ignoring the fact in front of it. The situation with S corporation compensation is just the latest.