3 IRS audit risks for S corporation owners

Audits by the Internal Revenue Service happen.

The fear of an audit is, in my experience, overblown. They’re relatively rare, and you have nothing to fear as long as you can justify the numbers you’ve reported on your tax returns.

In general, the more complex your tax situation, the more opportunities you have to be selected for an audit.

Adding an S corporation to your personal financial portfolio adds another opportunity to face an IRS audit. (State income and unemployment tax agencies may also have occasional questions for you.)

S corporation owners specifically face three types of IRS audit risk:

1. Underreporting income

2. Losses in excess of basis

3. Unreasonable officer compensation

The first risk—underreporting income—is an easy fix: have solid, independent records of all revenue collected and expenses paid; in other words, have good bookkeeping. (This is why I require all of my S corporation clients to have bookkeeping, and why I prefer to handle the books myself.)

Issues can still arise, even with solid bookkeeping in place.

• Some customers may (erroneously) issue a 1099-NEC to an S corporation.
• A payment processor, such as Stripe or Square, may issue a 1099-K for gross amounts collected, but the S corporation reported net deposits received as its gross revenue on the return.
• A shareholder may misreport K-1 income on her Form 1040 individual tax return due to an error.

These should trigger a notice from IRS. Having sufficient records in place and a reasonable explanation to match should mitigate any audit risk.

The second risk—losses in excess of basis—has a similar mitigation strategy.

IRS should scrutinize relatively large S corporation losses claimed on a Form 1040 personal tax return. IRS will try to claim that the losses exceed basis and should be disallowed in the current year.

Proving basis requires either sufficient documentation of the shareholder’s contributions and reported profits over time or a careful reconstruction of her basis from reliable sources, such as K-1s and bank statements. Having that information ready to go should be standard practice.

The third risk—unreasonable officer compensation—deserves a post of its own for two reasons: first, it involves a different type of tax (payroll, not income); and second, the Treasury Department’s Inspector General recently published a report on how the IRS enforces its reasonable compensation rules, which deserves devoted discussion. So, more on that next time…