The Auditors Are Coming: Updates from the IRS on Enforcement Efforts

With the passing of the IRA22 last year and the ongoing battle over the funds allotted to the IRS in that legislation, there have been numerous updates about how the IRS plans to use whatever funding they do receive. The IRS has been consistent with their intent to use the funding to increase enforcement, particularly among high-net-worth individuals and complex pass-through entities such as partnerships and S Corporations. 

Here are some of the key points we’re seeing in recent updates regarding IRS enforcement: 

 

Increased Focus on S Corporations & Partnerships 

The IRS has formed a new group to improve tax compliance by high-income individuals and corporations. Plans for the group, a part of the IRS’s Large Business and International Division, will focus mainly on the use of large or complex pass-through entities, such as S corporations and partnerships, which are used intentionally to avoid paying taxes. [Read the full article] 

Using AI to Detect Compliance Issues 

“The changes will be driven with the help of improved technology as well as artificial intelligence that will help IRS compliance teams better detect tax cheating, identify emerging compliance threats and improve case selection tools to avoid burdening taxpayers with needless ‘no-change’ audits,” the IRS announced. [Read the full article] 

ERC & Reasonable Compensation Audits on the Rise 

“Recently the IRS has opened audits focusing on the employee retention tax credit, and also audits regarding reasonable compensation for services performed by shareholders of subchapter S corporations.” – Yvonne Cort, lead tax compliance and tax controversy partner at Capell Barnett Matalon & Schoenfeld [Read the full article] 

What can I/should I do to prepare? 

 

If you work with SMBs, particularly S Corporations, here are a few things you can do now to make sure your clients are in compliance. 

Shareholder employees must be paid via W-2. 

 

It’s the law. Even if the amount owed in taxes is the same if your client pays themselves via 1099, they can receive penalties for doing so if they are required to pay via W-2. 

FS-2008-25 states: Corporate officers are specifically included within the definition of employee for FICA (Federal Insurance Contributions Act), FUTA (Federal Unemployment Tax Act) and federal income tax withholding under the Internal Revenue Code. 

Generally, an officer of a corporation is an employee of the corporation. The fact that an officer is also a shareholder does not change the requirement that payments to the corporate officer be treated as wages. 

Shareholder employees must receive reasonable compensation before taking distributions.  

 

If you have S Corp owners that have received distributions and not paid themselves via a W-2, you might as well go ahead and paint a target on your back. Equally as dangerous are those S Corp owners who pay themselves an unreasonably low salary in an attempt to skirt payroll taxes. Based on the recent updates from the IRS, this is exactly the kind of thing they will be looking for in their enforcement efforts. If you’re not sure if the owner’s salary is reasonable, use a tool like RCReports to pull a detailed reasonable compensation analysis for them. 

You must have documentation to back up reasonable compensation.  

 

The IRS and tax courts have made it clear that “companies have the burden of showing that compensation is reasonable… and should keep records indicating the duties performed by its employees and the hours those employees worked.”(IRS Job Aid pg 12) 

To put it another way, companies have the responsibility to demonstrate the reasonableness of the S Corp owner’s compensation, and the best way of doing so is with credible independent research and documentation. 

What if my clients haven’t handled compensation correctly in the past? 

 

There’s still time to fix any errors for 2023 returns, and we recommend you take care of that as soon as possible. But you may have clients that haven’t paid themselves via W-2 or didn’t take reasonable compensation in years prior and that can be trickier to handle. 

While you can go back and amend prior year’s returns, it’s likely going to be time-consuming and expensive for you and your clients. Your other option is to simply wait and see if your client is chosen for an audit and handle it with the examiner if they are. Here’s a great article that details what you can do in the event of an IRS audit. As their advisor, you should consider both options for each specific client and decide on the best route forward. 

The most important and practical thing you can do moving forward is have a proactive strategy when it comes to reasonable compensation. Make sure all your S Corp owners are paying themselves via W-2 and make it a requirement that each of your S Corp owners complete a reasonable compensation analysis every year that you can keep with your workpapers in case of future audit. 

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