Small Business Taxes & Management^TM--Copyright 2005, A/N Group, Inc.

Internal Revenue Service officials have announced (IR-2005-76) the launch of a study to assess the reporting compliance of S corporations. The study, carried out under the National Research Program (NRP), will examine 5,000 randomly selected S corporation returns from tax years 2003 and 2004.

S corporations are entities whose income and deductions pass through the corporate structure to the shareholders. Since the mid-1980s, the number of S corporations has risen rapidly, growing from 724,749 in 1985 to 3,154,377 in 2002. The growth rate has been even faster among S corporations with more than $10 million in assets. From 1985 to 2002, the number of these larger S corporations grew more than ten-fold, from 2,305 to 26,096.

IRS Commissioner Mark W. Everson said "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."

S corporations are now the most common corporate entity. In 2002, the latest year for which data is available, S corporation returns accounted for 59 percent of all corporate returns filed for that tax year. Two million S corporations reported net income of about $248 billion and 1.2 million S corporations reported net losses of about $63 billion.

Numerous restrictions and requirements still apply to S corporations. For example, an S corporation can have no more than 100 shareholders and none of these can be another corporation or non-resident alien. An S corporation can have only a single class of stock and convertible debt is not allowed. But many of the restrictions in the original legislation have been relaxed. For example, an S corporation can have a subsidiary, family members may qualify as a single shareholder, and certain exempt organizations and trusts may be shareholders. In addition, the IRS has relaxed it's rules with respect to the making of an S election and inadvertent terminations.

Program officials expect these audits to begin later this year. The last reporting compliance study of S corporations involved about 10,000 returns from tax year 1984, prior to the tax law changes that spurred the growth in S corporations. The new NRP initiative will use a study approach designed to reach statistically valid conclusions regarding compliance behavior, while using a smaller sample of returns than in the past.

While the IRS did not provide details on the depth of an audit, these studies often entail an detailed review. That probably includes employment records such as 941s and state returns, substantiation for expenses, auto and T&E diaries, etc. The only good news is that your chance of getting audited is less than 1 in 500.

The results of the NRP study will be used to more accurately gauge the extent to which the income, deductions and credits from S corporations are properly reported on returns filed by the flow through corporations and their shareholders. When completed, this research will assist the IRS in selecting and auditing S corporation returns with greater compliance risk.

The research program on S corporations is a complement to the study of individual reporting compliance completed last year. The preliminary results from that study, announced in March, indicated that the gross tax gap is more than $300 billion each year. IRS collection and compliance efforts reduce this gap by about $50 billion each year.

The NRP, created in 2000, is a comprehensive effort by the IRS to measure payment, filing and reporting compliance for different types of taxes and various set of taxpayers.

--Last Update 07/26/05