Winchester Presents A Tax Policing Paradox Today At Wisconsin

Richard Winchester (Seton Hall; Google Scholar) presents A Tax Policing Paradox at Wisconsin today as part of its Business, Tax, and Compliance Colloquium hosted by Nyamagaga Gondwe:

If the government audits more taxpayers, that generally leads to higher levels of taxpayer compliance. However, this does not always happen. If the government audits taxpayers and fails to detect a specific form of tax evasion, taxpayer compliance will fall in two respects. The audited taxpayers will continue to engage in the practice that went unnoticed. In addition, as word spreads that the risk of detection or penalty is low, other taxpayers will start to engage in the same form of tax evasion.

There is one specific form of tax evasion that is unlikely to receive the scrutiny it deserves even as the Internal Revenue Service gears up to spend a huge injection of money to police taxpayers more frequently. It is often called the S corporation employment tax dodge and it works like this. If a closely held S corporation has an owner who also works for the firm, that individual can access the company’s earnings in two ways: as compensation for their work or as a distribution of profits. The main difference is that distributions are not subject to employment tax, while compensation is. So, the low-tax option is for the employee-owner to work for free and to cause the firm to pay them a distribution that is nothing more than disguised compensation.

The government has been aware of this unlawful practice for decades. However, when the I.R.S. audits S corporations, the agency frequently does not scrutinize the amounts the owners receive for their work, even when there is reason to believe that the firm paid the owner a distribution as disguised compensation. The I.R.S. is unlikely to change how often it scrutinizes this practice, no matter how much money it can spend on audits. That’s because the law governing this area is subjective and fact specific, which makes it costly and time consuming to enforce. On top of that, the effort it takes to enforce the law frequently is not worth the revenue the agency might collect. So, unless the I.R.S. defies this cost-benefit assessment, an increase in S corporation audits will simply inspire more audited firms to disguise compensation as distributions in future years, while inspiring a greater number of other firms to begin doing so.

This tax policing paradox would not exist if Congress enacted an objective rule to replace the subjective one to determine a shareholder’s compensation. The I.R.S. would be more likely to enforce such a rule, and taxpayers would be more likely to obey it.