Evan is the sole shareholder of Magic Roofing Company, a calendar year S corporation. Although Evan spends at least 30 hours per week supervising Magic’s employees, he has never drawn a salary from Magic. Magic has been in existence for five years and has earned a profit every year. Evan withdraws $50,000 of cash from the S corporation each year.
a. Explain the tax consequences of Evan’s cash withdrawals from the S corporation and their impact on Evan’s taxable income and Magic’s ordinary income.
b. An IRS agent has just begun examining the last three years of tax returns filed by Evan and Magic. He has questioned whether the $50,000 withdrawals should be characterized as salary payments to Evan instead of shareholder distributions. What are the income tax consequences to Evan and Magic if these distributions are characterized as salary payments?
c. What are the payroll tax consequences to Evan and Magic if the distributions are characterized as salary payments?
Calculate the total potential underpayment of both employee and employer payroll tax that could result from this audit.