Three Common Errors, S-Corporation Shareholders and W-2s
- Published: 12/20/2013
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S Corporations are the second most popular form of doing business in the United States. According to the IRS, there are nearly 4 million S corporations in the United States, second only to sole proprietorships. From the year 2000 to 2006, the number of S corporations in the United States grew by approximately 35%. There are now twice as many S corporations as C corporations in the United States. Tax returns filed by S Corporations, Form 1120S, account for 70% of corporate returns filed with the IRS.
Why S Corporations are Popular: There are three basic reasons S Corporations have grown in popularity. These include:
- The potential ability to deduct business losses on the shareholder’s personal return,
- Potential avoidance of the double taxation that can occur with the earnings and dividends of C Corporations, and
- The potential reduction of employment taxes.
Increasing Scrutiny: S Corporations can be a beneficial form of business entity - benefits which can include tax savings, so long as the rules that govern S corporation taxation are followed. Failure to follow these rules, however, is why a growing number of S corporations and their shareholders find themselves increasingly scrutinized by the IRS. This increased scrutiny stems from the Treasury Department’s increasing effectiveness in matching the items reported by S Corporations to the tax returns of their shareholders.
Three Common W-2 Errors
Although there are many ways shareholders can run afoul of IRS rules, this column will look at three of the most common which impact W-2 reporting:
- Failing to a pay reasonable wage to shareholder-employees on Form W-2,
- Not reporting the personal use of a company owned vehicle as compensation on the shareholder’s W-2, and,
- Misreporting shareholder health insurance in Box 1 of Form W-2.
Error 1: Reasonable Wage:
As mentioned above, one of the benefits of S corporation ownership is the potential ability of the owner to reduce employment taxes. Perhaps the most common and potentially costly mistake made by S corporations is failing to pay a reasonable wage to shareholders for services provided to the business. Noncompliance in this area is so pervasive that the Treasury Inspector General stated the following in a 2005 report (2005-30-080):
- In tax year 2000, over 36,000 single-owner S corporation with net incomes of over $100,000 reported no W-2 income to owner-officers on their corporate returns.
- These same 36,000 corporations distributed over $13 billion in profits to their owners without paying a penny in payroll taxes.
- In 2000, single-owner shareholders paid $5.7 billion less in payroll taxes than they would if they had been taxed as sole proprietors.
A 2009 General Accounting Office Study (GAO-10-195) reinforced the need for increased S Corporation scrutiny when it found that in 2003 and 2004, S corporations under-reported owner compensation by over $24 billion. Considering the tax revenues lost due to non-compliant S corporations, the growing national debt, and the size of the Tax Gap (a measure of tax revenues lost due to noncompliant tax payers) it is really no surprise that S corporations are becoming the focus of increased enforcement efforts. This focus is expected to become even more targeted due to the impact wage calculation has in calculating the new 0.9% Medicare Surtax and the 3.8% Net Investment Income Tax which are part of the Affordable Care Act.
Avoiding Scrutiny: Although we do not have time in this article to discuss calculation of a reasonable wage, the easiest way to avoid the reasonable wage issues is to answer the following question: If you perform services for an S corporation in which you have an ownership interest, how much would you pay someone else to perform the same services? Pay yourself at least this amount. To substantiate the wage you choose, do some research (there are a number of online earnings survey websites) on how much someone performing the same services are paid and document the results.
The worst action you can take is to pay yourself nothing.
Error 2: Personal Use of Business Auto:
A second area that S corporation shareholders run into W-2-reporting-trouble is failing to report the personal use of business-owned autos as taxable wages on Form W-2. With limited exceptions for certain types of vehicles such as certain delivery trucks, fire and law enforcement vehicles, and buses, the personal use of an employer’s vehicle is taxable income to the employee and should be reported as compensation on both Form 941 and the employee’s W2.
The owners of businesses that perform certain professional services should be especially careful when depreciating and expensing a business-owned auto. Although many types of businesses such as those involving real estate and insurance, may require substantial driving, an auditor may become extremely critical of an owner-shareholder claiming 100% business use of a passenger vehicle: Claiming that they have never driven the vehicle home, stopped by the grocery store, or picked the kids up from soccer practice is questionable.
Protecting Yourself: The easiest way to avoid the IRS denying your business auto expense and re-characterizing it as taxable wages is to properly report the personal use of a business vehicle as taxable compensation on Form W-2. There are three basic rules that govern the calculation of taxable compensation resulting from the personal use of an employer-provided vehicle: the Cents-Per-Mile Rule, Commuting Rule, and Lease Value Rule. These rules are too complex to discuss in this column. What is important, however, is that you recognize the need to track and report non-business use of a company vehicle as compensation on this year’s W-2.
Error 3: Health Insurance:
The final error made by shareholders (in this instance, those who own 2% or more of the S Corporation) on their W-2s is that of failing to include the value of their company-paid health insurance premiums in Box 1 (Wages, Tips and Other Compensation) and Box 14 (Other). Although the premiums are not subject to Social Security and Medicare tax, they are reported as income on the shareholder’s personal return. The shareholder can then deduct the premiums as an adjustment on page one of their Form 1040. Failure to report health insurance in this manner can result in the premium deduction being denied on the shareholder’s return.
This article has briefly discussed common errors S corporation shareholders make when reporting compensation on their Form W-2. For more information on the taxation of S Corporations please read my articles: S-Corporation, Loss Deduction Danger and S Corporations, The Good, The Bad, The Scary.
Please remember: This or any article does not constitute or replace the advice of a qualified professional. If you would like assistance with your S corporation or any taxes issue, please feel free to call our office at (304) 267-2594.