The decision by the Internal Revenue Service to launch a new compliance study of S corporations has drawn a mixed response from tax practitioners and industry groups.
The study, carried out under the National Research Program, will examine 5,000 randomly selected S corporation returns from tax years 2003 and 2004.
"The notion that the IRS is embarking on the hunt of small business merely as a way to learn more about how small businesses are adhering to tax compliance requirements is like heading off to the zoo in search of a safari," said Dan Danner, executive vice president of the National Federation of Independent Business.
"It's not fair for mom-and-pop businesses to deal with an audit when they've done nothing wrong, paid all their taxes and filled out the forms to the best of their ability," said Ryan Peebles, the NFIB's senior manager for legislative affairs.
"Audits scare people, and they end up having to hire accountants and lawyers just to hold their hand during the process," he continued. "It's a tremendous burden for a family-owned business to be put in this position."
Since the mid-1980s, the number of S corps 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, according to the IRS. From 1985 to 2002, the number of these larger S corporations grew more than tenfold, from 2,305 to 26,096.
"The use of S corporations has exploded," said IRS Commissioner Mark W. Everson. "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 pay their fair share."
E. Martin Davidoff, Tax Liaison Committee chairman of the American Association of Attorney-CPAs, agreed. "It's long overdue," he said.
"It's smart for them to do the study. The IRS gave us a long lead on it, and kept all of the groups representing practitioners informed," said Davidoff. "This is exactly what they should be doing, because there are a lot of S corporations out there. And as they did with the original NRP study, they are doing it in the least invasive way possible."
Moreover, Davidoff noted, there is a fair amount of abuse in this area. "People are taking salaries that are too low, sometimes as little as zero, to beat the 15 percent FICA tax. Or there are those who pay themselves $10,000, but take out $90,000 in distributions. Sometimes it's out of ignorance, but it's an area that they have to examine."
"They'll also find a lot of inappropriate deductions in small and midsized S corporations - those with from $75,000 to $300,000 or $400,000 in gross revenue," he continued. "These are basically one- or two-person shops. They may be running commuting expenses or vacations through there. I think they'll find a disproportionate amount of abuse, because it's an area they haven't audited. People who cheat the system will gravitate toward the less-audited entity."
Paul Gada, senior tax analyst at Riverwoods, Ill.-based CCH, was less supportive.
"It's not a good thing for S corporations," he said. "There probably is a compliance gap here, as everywhere, but it's not necessarily something willful. The tax code is extremely complex for business owners as well as individuals - a small business owner might have neglected something important because he failed to stay current with the tax changes."
"It's a good time for small business owners to review previous years' returns with a tax professional to see if they were claiming everything that they should, and if they were complying with the tax code," Gada said. "But it may create a dilemma for some owners. They have the option to go back and self-correct any inaccuracies from those years, or sit tight and hope they aren't one of the 5,000. It's not an enviable position."
The impetus for the S corporation focus is the result of the Social Security hearings earlier this year, according to David Mack, director of government affairs at the National Small Business Association.
"The hearings turned into an examination of S corporation abuse and the loss of payroll revenue to the federal government," he said. "While some things are indefensible - for example, taking a $5,000 salary and $95,000 in distributions - our membership is always concerned when the IRS decides to ramp up audits of small businesses. We recognize the importance of having good data, but we want to make sure the study is done fairly, with the least possible burden to taxpayers."
James Zelasko, tax counsel with the U.S. Chamber of Commerce, said that the audits probably constitute an unnecessary expense with little or no justification.
"We'll stay on top of the situation, and will try to ensure that it doesn't become a great burden on small business," he said.
The American Institute for CPAs likewise will monitor the process as it unfolds, according to Ed Karl, director of taxation.
"If a particular taxpayer goes through a burdensome experience, we'd like to hear about it," he said. "We'll be sending out questionnaires to get some feedback on how the process is working."
Karl noted that the study is being done so that the IRS can update its methods of finding returns that might potentially have problems. "They can't audit every return, so they try to identify the ones that have the most potential for problems using statistical analysis. They're trying to update data now so that future choices will be more accurate, and future audits will be less intrusive."
"The bad news is that the ones who are randomly selected will have to spend a bit of time answering questions, but in the future it will enable less taxpayers to be audited," noted Marc Hyman, technical manager for taxation, S corps, at the American Institute of CPAs.
"They can't do this very frequently, and have to use their resources wisely," he noted.
The last compliance study of S corporations involved about 10,000 returns from 1984, prior to the tax law changes that spurred the growth of S corps.
The research program on S corporations is a complement to the study of individual reporting compliance that was completed last year. The preliminary results from that study, announced in March, indicated that the gross tax gap is more than $300 billion, according to the IRS.
"This research effort provides us the knowledge we need to both improve compliance and reduce unnecessary taxpayer burden," said Everson.
Nevertheless, small business advocates continue to view the effort as an unnecessary burden.
"Small business owners are creating jobs, growing our economy and moving America forward all across the nation," said Danner. "They already have a job - running their businesses. The last thing they should have to be concerned with is the IRS putting a target on their back. The IRS's actions are likely to reap little more than another set of hoops that small businesses must jump through in the regulatory jungle of the federal government."
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