Today, S corporations are the most popular corporate form of doing business, with nearly 60% of all corporations now filing Form 1120S, U.S. Income Tax Return for an S Corporation. Electing to be taxed as an S corporation allows corporate owners to report their share of corporate income, deductions and other items on their personal returns, avoiding a potential "double tax" occurring in regular, or "C," corporations. But the popularity of S corporations may be jeopardized by an IRS announcement in July 2005 that it was starting a new audit project focused on S corporations.
Set to begin late in 2005, the IRS will randomly select 5,000 of the more than three million S corporation returns from 2003 and 2004 for intensive examination. As part of the National Research Program (NRP) begun five years ago, information gleaned from these audits will be used to better select returns for audit and to conduct more effective examinations in the future.
What Is The IRS Looking for?
The IRS has not spelled out what it is looking for in these examinations, but it can be surmised. This audit project is the result of the growing "tax gap" announced by the IRS in March 2005 -- the spread between collections and what the IRS thinks is due has risen to a net tax gap of nearly $300 billion. Thus, it is reasonable to expect that the key information the IRS is looking for on S corporation audits is unreported income.
For many industries, the IRS can deduce income omissions by looking at deductions claimed on a return. For example, if a pizzeria deducts a certain amount for the purchase of flour, the IRS concludes that it should have produced a set number of pies, resulting in reportable income of a certain amount. It has created dozens of audit guides for specific industries, from auto body repair shops to veterinarians (for access to these guides, go to www.irs.gov/businesses/small/article/0,,id=108149,00.html).
The S corporation audits can be expected to be intense, line-by-line scrutiny of all positions reported on the return; income omissions may not be the only audit target. The IRS will probably take this opportunity to examine other positions on S corporation returns, including common audit targets such as:
- Compensation paid to shareholder-employees. In S corporations there is a tendency to underpay owners in order to minimize Social Security and Medicare (FICA) taxes. From an income tax view, whether income is paid out as compensation or otherwise does not affect the taxation of the corporation or its shareholders, who report their share of corporate income on their personal returns. But from an employment tax view, underpaying compensation for work actually performed is viewed as an impermissible way to avoid employment taxes. The courts have supported the IRS position that shareholders who work for their corporations must take reasonable compensation for the work they do.
- Deductions--excessive or inappropriate write-offs. Problem areas include taking deductions for items that should be capitalized (e.g., costs that should be added to inventory rather than separately deducted) and travel and entertainment expenses that lack the necessary records and receipts to support them.
How to Protect Yourself
As an S corporation, you can't do anything to avoid selection for this audit other than cross your fingers and hope for the best. With about 3.2 million S corporations filed in each of the years under review, your odds are about one in six hundred that your company will face an audit under this program.
If you receive a letter from the IRS informing you of selection, don't panic. Instead, contact your tax advisor immediately. A tax professional knows how to proceed and what to say (and what not to say) during an audit.
You can also act to bolster the positions already taken on your return.
- Review recordkeeping. Make sure you have receipts and other documentation to support the deductions claimed on the return. Safeguard your information so you can make it available to the IRS if necessary.
- Set aside funds to cover audit expenses. Handling an audit can be very costly for your company. Create a war chest to pay your accountant or other tax advisor for handling this matter. Anticipate a minimum of approximately 40 hours of professional help to prepare for the audit, meet with IRS agents and follow up as needed. Depending on your advisor's hourly rate (typically $200 to $300 per hour, depending upon your location and advisor's expertise), expect to spend about $8,000 to $12,000--or considerably more if your tax situation is complex.