S-Corporation owners and their tax professionals can avoid accuracy-related penalties by maintaining accurate records throughout the year. They can also avoid these penalties by correctly completing the Form 1125-E.
In today’s post, I’ll explain how this one form can help shield your business from IRS accuracy penalties.
What are IRS accuracy-related penalties?
Let’s first discuss accuracy-related penalties and how those are assessed. Simply put, when the IRS finds errors on your tax return that are due to “negligence or disregard of the rules or regulations” or due to “substantial understatement” of your income tax, they can saddle you with accuracy-related penalties.
A “substantial understatement” for an individual means that you understated your tax liability by 10% or $5,000, whichever is more. If you claimed Section 199A Qualified Business Income Deduction on your tax return, the “substantial understatement” penalty is assessed if you understate your tax liability by 5% or $5,000, whichever is more.
If you’re assessed a penalty for negligence or disregard, the penalty is 20% of the tax you owed due to that negligence or disregard. For substantial understatements, the penalty is 20% of the tax that was understated on the submitted tax return. And don’t forget, the IRS charges interest on these penalties as well!
How can Form 1125-E help my S-Corporation avoid accuracy-related penalties?
Completing Form 1125-E–even if your business didn’t bring in $500,00 for the year–shows the IRS that you are doing your due diligence in accurately reporting your income. Will completing this form definitely get you out of all accuracy-related penalties? Nope, but it can certainly help if an auditor is reviewing your return.
It’s important to note, however, that as with any IRS form, you must complete Form 1125-E clearly and accurately. Of course, you’ll also need to follow the instructions the IRS provides. This is especially important when it comes to the numbers you’re entering on Form 1125-E. These dollar amounts must match the amounts you can show through payroll documents or money transfers on bank statements.
If you are audited, you’ll need to be able to provide financial documents that prove the amounts you entered are correct or that you were at least demonstrating “good faith” in providing those numbers to the IRS through Form 1125-E.
How does reasonable compensation play a part in protecting my S-Corporation from accuracy-related penalties?
The biggest red flag for the IRS when it comes to S-Corps reporting income is when the owner or employees are not earning reasonable compensation. “Reasonable compensation” is an IRS term that means the money the business is paying employees–including the owner–is an amount similar to what other businesses would pay those same employees to perform those same jobs in a similar market.
Determining reasonable compensation for yourself as an S-Corp owner is one of the first things you can do to make sure you avoid tax penalties (or paying too much in taxes!). If you haven’t done this yet, I highly recommend you invest in an S-Corp Reasonable Compensation Report. This report provides the documentation you’ll need if the IRS ever questions the amount you’ve chosen to pay yourself. I can’t stress enough how important this is to have on-hand for any S-Corporation.
If you’re looking for more free advice from a CPA to help make sure your S-Corporation is on-track, then take a few minutes to look through all of the S-Corporation topics on my blog. And if you need more individualized support, my team is just a click away.