Shareholders of an S-corporation, should be aware of potential Internal Revenue Service audit risk associated with shareholder transactions including:

• Reasonable compensation for services performed by shareholders,
• Loans between a shareholder and an S-corporation, and
• Distributions to shareholders.

The IRS looks closely at these shareholder transactions because they are popular mechanisms for income tax evasion.  

Reasonable Compensation:

An S-corporation is required to pay reasonable compensation for services performed by shareholders.  The term "reasonable" is based on an analysis of compensation paid for similar positions in other companies within the industry, time spent performing services and salary paid to other employees among other things. Trouble can arise when a shareholder who performs services takes funds in the form of a "draw" or "distribution" from its S-corporation.  If the amount of compensation paid to that shareholder is zero or below "reasonable", the IRS can reclassify the draws as wages subject to payroll taxes.   If this happens, additional penalties and interest are added to the tax bill resulting from the IRS adjustment.

Shareholder Loans:

The IRS looks closely at amounts classified as shareholder loans to determine whether a bona fide debt exists.  If a bona fide debt does not exist, a loan may be reclassified as a distribution which may trigger income tax under certain circumstances. 

The IRS looks at key questions such as (1) when the loan was made, and (2) is there a genuine intent that the borrowed funds will be repaid, and (3) is there a repayment schedule with maturity date, and (4) is there a written promissory note with interest charged?  Although these points are not all-inclusive, the major goal is determination of the parties' intent at the time of the transaction. 

Are Distributions Subject to Tax?

If it is determined that a shareholder loan is not bona fide debt but rather a distribution, the IRS will then determine the tax-ability of the distribution.  Here are some examples of when a distribution may be taxable:

1. An S-corporation has earnings & profits (E&P) from when it was a C-corporation.  If a shareholder takes a distribution that is greater than the cumulative total of undistributed net income (AAA account) then the distribution is taxed as an ordinary dividend up to the amount of E&P.

2. An S-corporation was never a C-corporation.  The basis of a shareholder loan has been previously reduced by losses since there was no stock basis.  The shareholder repays the loan.  Income recognition will result to the shareholder unless the basis of the note is fully restored before year-end. (The basis can be restored by allocation of pass-through income, if any.)  If a promissory note is in place and held for more than 12 months, the resulting income to the shareholder is capital gain.  If there is no certificate of indebtedness, the shareholder loan repayment is taxed at ordinary rates.