Majority of IRS Audits of Small Businesses Turn Up Nothing

A new government report finds that most S-corporation audits uncover very little.
Business Writers
July 30, 2012

According to a new report, most audits of small businesses are turning up, well, nothing much. This begs the question of whether the Internal Revenue Service may be wasting its time going after so many.

Nearly two thirds (62 percent) of the audits of small businesses deemed "S-corporations" are finding "no change," meaning no problems and nothing to correct, according to a report from the Treasury Inspector General for the Tax Administration (TIGTA).

A Waste of Time?

More than 98 percent of all S-corps have $10 million or less in assets, according to TIGTA. Unlike C-corporations (a group that includes most publicly traded businesses), S-corps do not pay federal income taxes. Instead, profits go directly to owners, who then pay income taxes on them. C-corporation profits are taxed twice: First as corporate income and then again as income to investors who receive dividends.

“These results are troubling because, according to the IRS, a high no-change percentage means the agency is spending a significant amount of resources on unproductive audits and burdening compliant taxpayers with unnecessary audits,” says J. Russell George, the inspector general, in a statement.

A Mounting Problem 

According to the IRS, the number of S-corp tax returns are continuing to rise as C-corp returns fall: In 2011, S-corps filed some 4.5 million returns (up 80 percent from the 2.5 million filed in 1997). That's more than double the number of C-corp returns. Currently, The IRS's Small Business/Self Employed Division says it helps some 57 million taxpayers, including about 41 million self-employed.

It's not clear exactly how much money the IRS collects from the audits—the report says this is "due to limitations with IRS databases"—but in fiscal years 2007 to 2011, 53,544 S-corp returns were audited, with $5.7 billion in adjustments reported to those returns. Audits were up 54 percent from the previous five-year period (FYs 2002 to 2006).

In other words, they won't be stopping audits any time soon. As the report notes, an S-corporation "presents a compliance risk because it provides shareholders with opportunities to structure transactions improperly to reduce the income taxes they would otherwise owe."

What will be the biggest red flags for audits going forward? The report—which is titled, believe it or not, "The Recommended Adjustments From S Corporation Audits Are Substantial, but the Number of No-Change Audits Is a Concern"—didn't drop clues. (Click here for some audit red flags from a tax lawyer.) It says only that the number of abusive transactions that would likely trigger an audit has risen from 10 in 2000 to 34 in January 2012, at least four of which involve S corporations. It recommended that officials "analyze S corporation data files to help identify additional productive returns for audit" and "revise classification guidelines to clarify that quality reviews need to be completed for each type of return classified."

Have you been audited? If you had to blame something (besides bad luck), what do you think triggered it?

Business Writers