Operating an S Corporation (S Corp) offers various tax advantages, but it also requires strict adherence to IRS regulations to avoid triggering audits. Here are common mistakes that can lead to increased scrutiny and how to prevent them:
1. Paying Unreasonably Low or No Salaries to Shareholder-Employees
The IRS mandates that S Corp shareholder-employees receive a "reasonable" salary for their services. Compensating yourself solely through distributions, or setting an unreasonably low salary, can raise red flags.
Prevention:
- Determine Reasonable Compensation: Base your salary on industry standards, your role, experience, and responsibilities. Regularly review and adjust compensation to reflect changes in duties or market rates. You can use our reasonable compensation calculator to help you determine your reasonable compensation.
- Document Salary Decisions: Maintain thorough records detailing how compensation amounts were determined, including any supporting research or benchmarks. With our reasonable compensation calculator, you will receive a downloadable PDF for your records.
2. Misclassifying Workers
Incorrectly classifying employees as independent contractors can lead to penalties. The IRS scrutinizes worker classifications to ensure proper tax withholding.
Prevention:
- Understand Classification Criteria: Familiarize yourself with IRS guidelines distinguishing employees from independent contractors.
- Classify Workers Appropriately: Ensure that all workers are correctly classified based on their roles and the degree of control the company has over their work.
3. Failing to File Necessary Forms and Meet Deadlines
Neglecting required filings or missing deadlines can attract IRS attention.
Prevention:
- Timely Filing: Submit all necessary forms, such as Form 1120-S and Schedule K-1s, by their respective deadlines.
- Stay Informed: Keep abreast of any changes in tax laws or filing requirements that may affect your S Corp.
4. Inaccurate Record-Keeping
Poor or inconsistent financial records can lead to discrepancies in tax filings, prompting audits.
Prevention:
- Maintain Detailed Records: Keep comprehensive and accurate records of all financial transactions, including income, expenses, payroll, and distributions.
- Regular Reconciliation: Periodically reconcile bank statements and financial records to ensure consistency and accuracy.
5. Claiming Excessive Deductions
Deductions that are disproportionately large relative to income can raise suspicion.
Prevention:
- Ensure Deduction Legitimacy: Only claim deductions that are ordinary and necessary for your business operations.
- Maintain Supporting Documentation: Keep receipts, invoices, and other documentation to substantiate all claimed deductions.
6. Mismanaging Shareholder Distributions
Improperly handling distributions, such as distributing profits without first paying reasonable compensation, can lead to IRS scrutiny.
Prevention:
- Prioritize Reasonable Compensation: Ensure shareholder-employees receive appropriate salaries before issuing distributions.
- Document Distribution Decisions: Keep detailed records of all distributions, including dates, amounts, and recipient information.
By proactively addressing these areas and implementing robust compliance practices, S Corp owners can minimize the risk of IRS audits and maintain the corporation's favorable tax status.
