IRS Launches Study of S Corporation Tax Compliance

By Paul Gada, CCH Financial Planning Toolkit Staff Writer

The IRS has announced it is beginning a study to assess the reporting compliance of S corporations. As part of the study, which started July 25, 2005, the IRS will randomly select for examination 5,000 S corporation returns from tax years 2003 and 2004. These audits will begin later in 2005, according to the IRS.

The purpose of the study is to help the IRS gauge the extent to which S corporations and their shareholders are properly reporting income, deductions and credits from S corporation operations. The information collected from the study will help the IRS develop criteria for selecting and auditing S corporation returns with greater compliance risk.

"This research effort provides us the knowledge we need to both improve compliance and reduce unnecessary taxpayer burden," said IRS Commissioner Mark W. Everson.

The study, carried out under the National Research Program (NRP), is designed to reach statistically valid conclusions regarding compliance behavior despite the relatively small number of returns sampled. The last study was conducted in 1984 and involved 10,000 randomly selected returns from 1984. At that time, there were approximately 725,000 S corporations in existence.

Since the mid-1980s, however, S corporations have grown at an amazing rate to become the most common corporate entity selected. In 2002, over 3.1 million S corporation returns were filed, accounting for 59 percent of all corporate returns filed for the year. S corporations reported net income of about $248 billion in 2002, with about a third of S corporations reporting net losses totaling $63 billion. The number of S corporations with more than $10 million in assets grew over ten-fold, from 2,305 in 1985 to 26,096 in 2002.

"The use of S corporations has exploded," said Everson. "The IRS needs a better understanding of what this means for tax compliance. This research is critical for achieving our strategic goal of ensuring that corporations and high-income individuals are paying their fair share."

As stated by the IRS, their ultimate goal is to detect noncompliance and otherwise improve overall compliance. Although understandable from their perspective, this translates to unwanted scrutiny and less money (e.g., more taxes assessed and higher tax prep costs) for taxpayers using the S corporation status.

Rather than worrying needlessly about an audit that may never come, now would be a great time for S corporations and their shareholders to review their tax matters with a tax professional. Taking a proactive role will avoid unpleasant surprises later. Plus, the IRS can't fault you if you are operating within established rules.

Also, try and focus on the positive. The American Jobs Creation Act of 2004 included many positive changes that are sure to make S corporations an even more popular entity choice. For example, starting in 2005, S corporations will be able to have 100 shareholders instead of 75. One family can also elect to be treated as a single shareholder. Such new rules provide greater options and flexibility to S corporations. Hopefully, the increased benefits of using this type of business structure will outweigh any drawbacks from the IRS snooping around for violations.

Above all, watch your step. Remember that the IRS may be watching you.

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Posted August 15, 2005.