Thomas Huckabee CPA Inc. Quarterly Newsletter March 2010

S Corporations and Taxes: Under the Microscope

If you operate an S corporation, you need to be aware that a recent Government Accountability Office (GAO) report has uncovered a number of tax filing issues that are contributing to the soaring “tax gap,” the difference between the annual amount of taxes owed and the amount voluntarily paid on time. With the aim of reducing this gap of approximately $345 billion, the report includes recommendations to eliminate filing errors and underreporting by S corporations.

S Corporations Defined

S corporations are the second fastest growing form of business, behind partnerships.

• In 2006, they constituted 13% of all business reports, filing 4 million returns for 6.7 million shareholders.
• They make up two-thirds of all U.S. corporations, representing 21% of all corporate receipts.
• Between 2000 and 2006, their assets and net income grew 46% and 67%, respectively.
• 60% of them had one shareholder and 84% had three or less.

Why They're Popular

The rising popularity of S corporations can be explained by three reasons:

• They provide limited liability for the owners.
• They avoid the corporate-level tax and pass through the tax items (income, deductions, etc.) to shareholders.
• Only wages paid by the S corporation are subject to employment taxes (1/3 of collected tax revenue).

Issues Uncovered by the GAO Report

The GAO report found that a significant percentage of the tax gap is created by problems with S corporation tax filings.

• 68% of all Forms 1120S misreported at least one item relevant to income calculation.
• Combined errors understated shareholder income by an estimated $85 billion.
• Common errors were the deduction of personal expenses and shareholder deductions of losses that exceeded their investment in stock and personal loans to the S corporation.
• 13% reported inadequate wage compensation.

Recommendations to Close the Gap

The GAO made a number of recommendations regarding noncompliant S corporations, including the following:

• A law change requiring the entity to include calculation of the shareholders investment (basis) with the K-1s
• More detailed IRS guidance on how to determine adequate shareholder compensation
• Licensing, penalties and education to reduce tax preparer mistakes
• Suggestions that Congress get involved in finding appropriate solutions

In addition, the IRS has gotten into the act, announcing two audit programs for 2010:

• The examination of 6,000 S corporations on all aspects and supporting documentation, to collect data for design of future S corporation tax audits
• The examination of 6,000 employment tax returns on all aspects and supporting documentation, to aid in designing future employment tax audits

What does this mean if you’re an S corporation? Now that you know the government is seeking additional funding through greater enforcement efforts, it might be a good time to take stock of your situation, before any potential IRS activity occurs.

Income Taxes In Simple Terms

We all know there are deficits to be repaid and taxes are the primary source if we are to get the U.S. into financial stability. Since the last election, we've consistently heard that taxes will only be raised on the rich (above $250,000/yr). This is political dogma.

We have a progressive income tax system, meaning that the higher your income, the higher the percentage of tax taken from it. The idea behind it is that it's "fairest" because the higher income earners (1) benefit more from the American system and (2) can more easily give up tax dollars. If income taxes were "flat," say 20% for all, the burden of government would fall harder on the less fortunate (i.e., a $2,000 tax to a person with $10,000 is harder than $200,000 to a person making $1,000,000). Let's put income taxes in terms everyone can understand. Here's an Internet urban story updated to use the latest tax information available (2007).

Suppose that every day, 10 men go out for dinner and the bill comes to $100. If they paid their bill the way we pay our taxes, it would go something like this:

• The first man (the poorest) would pay nothing.
• The second man would pay $1.
• The third and fourth men would pay $2.
• The fifth would pay $3.
• The sixth would pay $4.
• The seventh would pay $6.
• The eighth would pay $8
• The ninth would pay $11.
• The tenth man (the richest) would pay $62.

That's what they decided to do. The 10 men ate dinner in the restaurant every day and seemed quite happy with the arrangement, until one day, the owner threw them a curve.


"Since you are all such good customers," he said, "I'm going to reduce the cost of your daily meal by $20." Dinner for the 10 now cost just $80. The group still wanted to pay its bill the way we pay our taxes, so the first man was unaffected. One might still eat for free, but what about the other nine men, the paying customers? How could they divide the $20 windfall so everyone would get his “fair share?”

They realized that $20 divided by 10 is $2 each…but if they subtracted that from everybody's share, the first two men would each be paid to eat their meal. The restaurant owner suggested that it would be fair to reduce each man's bill by roughly the same amount, and he proceeded to work out the amounts each should pay. And so:

• The second man, like the first, now paid nothing (100% savings).
• The third and fourth men would pay $1 (50% savings).
• The fifth man paid $2 (33% savings).
• The sixth now paid $3 (25% savings).
• The seventh now paid $5 (17% savings).
• The eighth now paid $6 (25% savings).
• The ninth now paid $9 (18% savings).
• The tenth now paid $52 (16% savings).

Each of the nine was better off than before, and the first one continued to eat for free, but once outside the restaurant, the men began to compare their savings.


"We only got a dollar out of the $20," declared the second, third and fourth men, pointing to the tenth man, "but he got $10!"


"Yeah, that's right," exclaimed the sixth and seventh men. "I only saved a dollar, too. It's unfair that he got 10 times more than me!"


"That's true!!" shouted the eighth and ninth men. "Why should he get $10 back when we got only two? The wealthy get all the breaks!"


"Wait a minute," yelled the first man. "I didn't get anything at all. The system exploits the poor!"


The nine men surrounded the tenth and beat him up. The next night, the tenth man didn't show up for dinner, so the nine sat down and ate without him. When it came time to pay the bill, they discovered something important; they didn't have enough money between all of them for even half of it!

As the story illustrates, the "rich" already pay an enormous portion of the income taxes assessed. In fact, the top 4% of 2007 income tax returns paid over 52% of total tax collections. How does loading more taxes on them create a stronger economy? The "rich" invest their wealth in companies that create jobs and purchases that spread activity and opportunities throughout the economy. WE (all of America) need to convince OUR government to stop its spending excesses, NOT extract the funding for it from 4% of our taxpayers.

According to IRS figures from 2007, income taxpayers:

• Earning under $50,000 were 56% of taxpayers and paid 9% of the taxes
• Earning $50,000 to $100,000 were 27% of taxpayers and paid 18% of the taxes
• Earning $100,000 to $200,000 were 13% of taxpayers and paid 21% of the taxes
• Earning over $200,000 were 4% of taxpayers and paid 52% of the taxes

The U.S. Economy Snapshot: Real Time Debt Clock

As economic changes rain down on us with government spending up and fear of taxes headed the same way, it's hard to get a picture that fits it all together. The U.S. Debt Clock is one of the most accurate up-to-date debt information sources available.

Checkout http://www.usdebtclock.org

You'll see up-to-date numbers on:

• US Population, employment and unemployment
• Government, Mortgage, Credit Card & Consumer Debt
• Federal and State Revenue and spending
• GDP and the trade deficit
• Social Security & Medicare liabilities
• National Assets and more

Although the numbers are large it's easy to see the balance between wealth and consumption. Moving your cursor over any statistic will show you the credible source it's taken from. Our debt crisis is a pressing issue but America has a long history of triumph in confronting challenges.