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Focus on Finances

S corps are coming under closer scrutiny. How will it affect you?

Concerned that some owners of S corporations aren't paying their fair share of business taxes, the IRS has kicked off an aggressive campaign to identify potential abuses among S corps.

The IRS has recently started to examine 5,000 randomly selected S corp returns from the 2003 and 2004 tax years. A chief concern: whether some S corp owners are skimping on their salaries--or skipping them altogether--in favor of a larger dividend distribution, which isn't subject to self-employment taxes. "Historically, that's what people have tried to do, and that's one of the reasons the IRS is conducting these audits," says Deborah Schenk, Grossman Professor of Taxation at the New York University School of Law.

"Because in the past there were very low audit rates of S corporations, people were aggressive about taking low salaries and pulling them out as dividends," she says. "My guess is they'll be somewhat less aggressive as the IRS audits [them] and successfully argues that some of [the earnings] is really salary, but it's been labeled as dividends."

For its part, the IRS will have to consider a multitude of issues when building a case against a suspected offender. "It obviously is dependent on the industry, the skills and the education [of the owner], and the profitability [of the S corp]," according to Schenk. "There are lots of cases where the company is trying to take a deduction for too much salary. This is the reverse, where the company is trying to pay out too little salary, and there's been virtually no case law or guidance. It will be a case-by-case determination."

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This article was originally published in the January 2006 print edition of Entrepreneur with the headline: Focus on Finances.

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