IRS announces a multi-year effort to increase audits in flow-through entities

As tax season approaches, practitioners can expect the IRS to quickly expand its audit focus to flow-through entities, according to an IRS official.

IRS Small Business/Self Employed operating division Commissioner Faris Fink, speaking at the IRS Tax Forum in Charlotte, NC, on Aug. 8, announced that the IRS would focus on partnerships and S corporations for audit for at least the next three years, starting in October. The IRS will use more of its audit resources for the 3.4 million partnership returns and 4.4 million S corporations filed annually.

In 2011, the IRS audited very few of these entities - only 13,770 partnerships and 18,519 S corporations, representing 0.4% of total returns filed. Compared to the overall 0.9% audit coverage rate for individuals and businesses, partnerships and S corporations have not seen much scrutiny.

A closer look

Several studies have indicated that the IRS needs to address noncompliance or at least identify ways to better examine flow-through entities. In July 2012, the Treasury Inspector General for Tax Administration (TIGTA) released a study on S corporation compliance that found an average of $105,534 in adjustments per return changed.

However, TIGTA studies also concluded that partnerships and S corporations have high "no-change" rates for audits on computer-selected returns, with 50% for partnerships and 62% for S corporations. According to the 2011 IRS Data Book, the overall no-change rates for partnership and S corporation field audits from all selection methods in 2011 were 46% and 39%, respectively.

From 2009 to 2010, the no-change rate for partnership field audits increased 19%. Overall, partnership and S corporation examinations underperform in comparison to no-change rates for individual audits (18%) and C corporation audits (29%). In short, the IRS is seeing fewer results on partnership and S corporation audits, especially with computer-selected returns, and it doesn't know why.

High no-change rates in flow-through entity audits are inconsistent with what the IRS knows about small business noncompliance from its tax gap studies, which show that sole proprietorships have a 56% misreporting rate and are the largest segment contributing to the tax gap.

More than 60% of S corporations have only one owner, so most S corporation returns are similar to sole proprietorship returns. Compared to field audit no-change rates of 10% for sole proprietorships, the high no-change rates for S corporations may warrant a closer look to see whether the IRS is correctly selecting returns for audit. For the IRS, "a closer look" generally means more audits and compliance projects to understand S corporation entities and common areas of noncompliance.

At the IRS Tax Forum, Fink did not say which areas the IRS would focus on initially, but he did say that the initiative would be a slow, deliberate learning process. Fink said that the IRS would start with partnership returns in late 2012 and then move to S corporation returns. The IRS is training additional revenue agents to examine these entities.

Practitioners will likely see a focus on the following:

• Losses deducted that are in excess of basis
• Loss limitations due to at-risk rules and passive activity rules
• S corporation officer compensation
• Unreported income
• Abusive tax avoidance transactions

What you can do for your clients

Practitioners need to exercise normal care and due diligence in preparing these returns. The IRS knows that more than nine out of 10 partnership and S corporation returns are completed by a tax professional. Follow these tips to help your clients in the event of an audit: