Eliminating dividend risk on IRS audit by electing S status.

• Author: Ellentuck, Albert B.

Facts

Frank is the sole shareholder of Franklin Ink, Inc., a C corporation in the printing and advertising business. Frank devotes most of his time to meeting and entertaining customers, and also traveling to solicit new accounts. Because of his efforts, the corporation has enjoyed increasingly high profits. For its most recent tax year, the corporation's taxable income exceeded $100,000, even after Frank withdrew $250,000 as salary and commission income.

Frank is a notoriously poor recordkeeper and has placed a low priority on improving his documentation. Much of his entertaining is done with cash and is poorly documented. Frank has a separate corporate checking account that he uses for travel expenses, and this account is frequently out of balance.

Issue

How would an S election help Franklin Ink, Inc. provide some audit protection?

Analysis

The tax adviser begins the analysis of tax exposure from an audit by estimating the potential changes that might be made to both the corporation's Form 1120 and Frank's personal Form 1040. Assume that about $30,000 of travel and entertainment per year is poorly documented and might be disallowed under Sec. 274(d). Further, there is a risk of about $50,000 of Frank's compensation being disallowed as excessive. The consequences of these adjustments while Franklin operates as a C corporation with the tax results if Franklin operated as an S corporation are shown above.

C corporation IRS adjustments Form 1120 Form 1040 Total Disallowed travel and entertainment $30,000 $30,000 $ 60,000 Excess compensation 50,000 -- 50,000 Total increase to taxable income 80,000 30,000 110,000 Marginal tax rate x 39% x 39.6% -- Tax increase $31,200 $11,880 $ 43,080 Any travel and entertainment expense disallowed to the corporation would likely be treated as a deemed dividend to Frank, because of the personal benefit involved with most of the expenditures and, accordingly, would result in double...