Unpacking the Increased IRS Enforcement in IRA22 for S Corps

By Paul S. Hamann & Jack Salewski, CPA, CGMA

The Inflation Reduction Act of 2022 (IRA22) was signed into law on August 16, 2022. The goal of the package is to raise $737 billion in revenue over the next decade, with $127 billion of that revenue coming from increased IRS enforcement. While it will take time before we understand the full implications of the bill, there are steps you can take now to ensure you and your clients are protected when the IRS ramps up examinations.

What we know about the increase in IRS budget

The legislation increases the IRS budget by about $80 billion over the next ten years. In exchange for this increase in budget, they are expected to bring in an additional $207 billion in revenue, resulting in a net of $127 billion.

The budget increase at the IRS is expected to be spread among enforcement efforts, operations support, taxpayer services, and business systems modernization. As you can see in the chart below, enforcement will be the largest recipient of funds, bringing the enforcement budget over the next 10 years up to almost $112 billion.

Figure 1: IRS Budget Authority through FY2031 Under the Inflation Reduction Act of 2022

IRS Budget increases through 2031
[Source: Congressional Budget Office, Inflation Reduction Act, via Brendan McDermott, “IRS-Related Funding in the Inflation Reduction Act,” Congressional Research Service, updated Aug. 9, 2022, https://crsreports.congress.gov/product/pdf/IN/IN11977; author’s calculations.]

While many who opposed the bill suggested that the increased enforcement would negatively impact the average taxpayer, Janet Yellen, the Treasury secretary, has said otherwise in a letter to the IRS commissioner last week:

“Specifically, I direct that any additional resources—including any new personnel or auditors that are hired—shall not be used to increase the share of small business or households below the $400,000 threshold that are audited relative to historical levels. This means that, contrary to the misinformation from opponents of this legislation, small business or households earning $400,000 per year or less will not see an increase in the chances that they are audited.

Instead, enforcement resources will focus on high-end noncompliance. There, sustained, multiyear funding is so critical to the agency’s ability to make the investments needed to pursue a robust attack on the tax gap by targeting crucial challenges, like large corporations, high-net-worth individuals and complex pass-throughs, where today the IRS has resources to initiate just 7,500 audits annually out of more than 4 million returns received.”

While it seems clear the increase in budget should be used to target these high-net-worth individuals and corporations, we haven’t been given much direction on how the increase in IRS staffing will affect existing staff and resources. One could arguably assume this shift will free up time of the existing staff to increase audits of the “average taxpayer” but only time will tell.

What does this mean for me and my clients?

So, while we don’t yet know exactly how many new examiners the IRS will bring in, or exactly when they will be ready to hit the ground running with audits, we do know that they are coming and are specifically looking to raise revenues through compliance, back taxes, penalties, and interest, particularly from high-net-worth individuals and businesses (including S Corps). Our best guess is that you’ll start to see an increase in audits within 1-2 years and typically an examiner is going to look 2-3 years in the past. That means that the taxes you’re filing for your clients this year will be prime audit fodder for these new agents.

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 comments from the Treasury secretary, this is exactly the kind of thing the IRS 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 2022 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.

 

To learn more about other tax implications of the bill, read this article from Thomas A. Gorcynski, EA, USTCP.



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