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.
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:
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.