68% of S Corp Tax Returns Have Errors says Government Accountability Office (GAO)

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The Government Accountability Office today released Tax Gap: Actions Needed to Address Noncompliance with S Corporation Tax Rules (GAO-10-195):

According to IRS data, about 68% of S corporation returns filed for tax years 2003 and 2004 (the years data were available) misreported at least one item. About 80% of the time, misreporting provided a tax advantage to the corporation and/or shareholder. The most frequent errors involved deducting ineligible expenses, which could decrease S corporation shareholder tax liabilities. Even though a majority of S corporations used paid preparers, 71% of those that did were noncompliant. Stakeholder representatives said that preparer mistakes may be due to the lack of preparer standards as well as their misunderstanding of the tax rules. Shareholders of S corporations also made mistakes in calculating basis – their ownership share of the corporation – when taking losses passed to them from the corporation, potentially decreasing their total taxes. IRS officials as well as stakeholder representatives said that calculating and tracking basis was one of the biggest challenges for shareholders, and that S corporations themselves were in a better position in most cases to calculate basis for their shareholders.

To improve compliance with shareholder basis rules, Congress should require S corporations to calculate and report shareholder’s stock and debt basis as completely as possible. S corporations would report the calculation on the Schedule K-1 and send it to shareholders as well as IRS. If Congress judges that stock purchase price information that is currently only available to shareholders should not be transmitted to the S corporation due to privacy concerns, an alternative is to require that S corporations report less complete basis calculations using information already available to the S corporation.

To help address the compliance challenges with S corporation rules, we recommend that the Commissioner of Internal Revenue take the following four actions:

  • Identify and evaluate options for improving the performance of paid preparers who prepare S corporation returns, such as licensing preparers and ensuring that appropriate penalties are available and used.
  • Send additional guidance on S corporation rules and record-keeping requirements to new S corporations to distribute to their shareholders, including providing guidance on calculating basis and directing them to the specific IRS Web site related to S corporation tax rules.
  • Require examiners to document their analysis such as using comparable salary data when determining adequate shareholder compensation or document why no analysis was needed.
  • Provide more specific guidance to shareholders and tax preparers, such as that provided to IRS examiners, on determining adequate shareholder compensation through means such as IRS’s Web site.

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  • I’m not sure why you are getting angry about the tax he will owe. Everyone has to pay tax to fund all the thnigs we take for granted (like the NHS, or decent roads, etc). By definition tax is a fraction of income / profit, so if he is paying a lot of tax then he is also making a lot more for himself.Your husband owns, and is possible also employed by, his Ltd company.If he is not an employee then his only income from the company will be dividends. These are paid out of profit after corporation tax has been paid. So, first the company calculates its profits. These are then subject to corporation tax at 20% (assuming profit under a3300,000). Some or all of the taxed profit can then be distributed as a dividend. Up to the basic rate income tax limit (about a342,000) there is no further income tax to pay because the dividends are paid as if basic rate tax had already been deducted. If the dividends take the recipient into the higher rate tax bracket then they need to top up the tax to the higher rate. On dividends the basic rate is 10% and the higher rate 32.5%. So the top-up is essentially a further 22.5% of the amount over the basic rate threshold.If you husband is an employee then the company will pay him a salary in the same way as any other employee. This will be liable for income tax and national insurance deductions via PAYE. However, salaries and associated costs are an expense of the company, so they reduce the profit, so corporation tax is not payable on this amount.Its possible for the salary to take the whole profit of the company, but it might not. In which case your husband could take some income as a salary and some as a dividend.Which blend of these options results in the lowest overall tax bill depends on your exact circumstances. You would need an accountant to look at everything to give a definite answer.Be aware, even if you want to have income paid to the company then to receive it as dividends, HMRC will not always allow this. If you are a contractor for a single company and you work in the same way as an employee of that company, then HMRC require you to be taxed as an employee ie to pay income tax and NI on the income. But I suspect this does not apply if your husband works from home.If your husband is paying higher rate tax, and you do not, then he may be able to reduce the tax bill by making you a shareholder in the company. That way you could receive dividends up to your basic rate tax threshold, which would reduce the overall tax paid.There may also be many other ways to reduce your company or personal tax bills. A few hours with an accountant may well pay for itself.