Seventh Tip to Help Avoid a Tax Audit:

Tax Forms, Audit

The IRS continues to have several audit watch areas for compliance through 2013.  Small businesses are going to be a major focus this year.  This includes corporations, partnerships and sole proprietors.   While you never know when you may be selected for an IRS Tax Audit, these tips will help you understand what the IRS will be focusing on through the 2013 tax season.

Audit Watch Area number 7 “S corporations, with an emphasis on losses in excess of basis and reasonable compensation paid to officers:

The IRS is interested in S corporation audits in which losses are taken in excess of basis on shareholder returns. The IRS will review basis computations in these audits to determine whether tax preparers are properly completing due diligence requirements before deducting losses on Form 1040. The IRS is also interested in the use of S corporation distributions to avoid payment of Social Security taxes. The IRS will focus on S corporations with income, distributions and little or no salary paid to officers.

Basis schedules are now required as part of an individual tax return when reporting losses from a pass-through entity.  A person cannot deduct more than what they have invested or left in the company.  For example, if you spend $500 to buy Microsoft stock, this is your initial basis.  If you reinvest any dividends, these dividends increase your basis.  If for some reason, this stock were to become worthless, the most you will be able to incur as a loss will be the $500 plus any reinvested dividends, nothing more.  Another way to explain basis would be, all monies that are invested in a company that have already been taxed.

There is little guidance as to what “reasonable” compensation is or how to compute it.  Our office uses several tests to make this determination.  There is not a set formula and it varies by company and by each individual.

  1. What would you be paid by a third-party to perform these same functions?
  2. What are your living expenses?
  3. Allocation between compensation and distributions.
  4. And the all-important “smell test”, also known as a “gut test”.

If the IRS determines that the compensation paid was too little, they will reallocate part or all of the distributions as compensation.  This recalculation will increase payroll taxes and late payment penalties will be assessed for the newly calculated taxes.

 

If you’re in need of a CPA, contact Jennifer Farnsworth of Farnsworth & Associates, PC.