Eliminating dividend risk on IRS audit by electing S status.

Facts

Frank is the sole shareholder of Franklin Ink, Inc., a C corporation in the printing and advertising business. Frank devotes most of his time to meeting and entertaining customers, and also traveling to solicit new accounts. Because of his efforts, the corporation has enjoyed increasingly high profits. For its most recent tax year, the corporation's taxable income exceeded $100,000, even after Frank withdrew $250,000 as salary and commission income.

Frank is a notoriously poor recordkeeper and has placed a low priority on improving his documentation. Much of his entertaining is done with cash and is poorly documented. Frank has a separate corporate checking account that he uses for travel expenses, and this account is frequently out of balance.

Issue

How would an S election help Franklin Ink, Inc. provide some audit protection?

Analysis

The tax adviser begins the analysis of tax exposure from an audit by estimating the potential changes that might be made to both the corporation's Form 1120 and Frank's personal Form 1040. Assume that about $30,000 of travel and entertainment per year is poorly documented and might be disallowed under Sec. 274(d). Further, there is a risk of about $50,000 of Frank's compensation being disallowed as excessive. The consequences of these adjustments while Franklin operates as a C corporation with the tax results if Franklin operated as an S corporation are shown above.

  C corporation
 IRS adjustments      Form 1120   Form 1040     Total
Disallowed travel
 and entertainment     $30,000    $30,000     $ 60,000
Excess compensation     50,000         --       50,000
Total increase to
 taxable income         80,000     30,000      110,000
Marginal tax rate      x   39%    x  39.6%          --
Tax increase           $31,200    $11,880     $ 43,080

Any travel and entertainment expense disallowed to the corporation would likely be treated as a deemed dividend to Frank, because of the personal benefit involved with most of the expenditures and, accordingly, would result in double taxation. Frank has already reported the disallowed excess compensation, however; reclassification of this payment results in additional corporate tax but does not change his overall taxable income. However, the reallocation from salary to dividend could have a positive impact if Frank's investment interest expense deduction was limited by insufficient net investment income.

Conversely, if Franklin were to make an S election, any changes made to corporate deductions would have an impact only on Frank's individual Form 1040. The excess compensation issue would disappear entirely, simply because all income from the corporation would be reportable on Frank's personal return either as S corporation earnings or as salary; the classification between the two categories would be insignificant (there would be no additional employment tax liability, because Frank's reported salary already exceeds the maximum earnings threshold for FICA coverage). Accordingly, the tax increase on IRS audit under S status would be $11,880, the disallowed travel and entertainment expenses ($30,000) taxed at Frank's marginal tax rate (39.6%). Thus, an S election would remove approximately $31,000 of tax risk from IRS audit per year.

Conclusion

An S election can be a valuable tool for minimizing the risk of additional tax, penalties and interest resulting from an IRS audit adjustment. This is particularly true when those adjustments would involve either an excessive compensation issue or disallowed corporate expenditures that could be characterized as constructive dividends to the shareholder.