For those who missed it, Monday’s Congress Daily does an excellent job of outlining the challenge confronting S Corporations and other flow-through businesses as Congress prepares to take up reconciliation, tax reform, an extension of expiring tax provisions, and other tax legislation this Congress. Continued interest by the press regarding the Joint Committee’s recommendation is a clear signal this issue is not going away…
JCT and the Treasury Department’s Inspector General for Tax Administration have proposed changing the rules to ensure that payroll taxes are levied on all a firm’s income, regardless of how it is counted. Concern in the small business community that Treasury might back a rule change of that nature was heightened when the IRS announced late last month that it was auditing 5,000 S-corporations with an eye toward recommending potential policy changes.”
SOME STARTING TO QUESTION THE IRS’ AUDIT OF S CORPORATIONS…
Last Friday’s BNA Tax Report suggests the IRS’ announcement that it intends to randomly audit 5,000 S Corporations over the next couple of years has left some tax practitioners questioning why the IRS is only targeting S Corporations. “While several practitioners could list areas of possible S corporation noncompliance, many also said they were not aware of any egregious, widespread violations currently occurring. Other practitioners noted several compliance problems may be more prevalent in S corporations than with other types of corporate structures.”
August 8th, 2005
Business Groups Prep For Battle Against S-Corp. Change
Small businesses are fighting a proposal to collect more payroll taxes from millions of S-corporations and partnerships, a plan they fear might be used by tax writers to help underwrite expensive Social Security or tax overhaul efforts. The proposal was floated earlier this year by the Joint Committee on Taxation, which estimates it would raise $57 billion over the next 10 years. That represents one of the largest revenue sources from a single legislative change, as congressional tax writers seek options to shore up the long-term solvency of Social Security and to change the tax code. Congress is awaiting recommendations from President Bush’s tax panel at the end of next month. “The tax panel’s charge is to report recommendations that are revenue-neutral … They’re going to have to come up with offsets someplace,” said Brian Reardon, a former White House economic adviser who is coordinating business efforts against the tax change.
At issue are amounts that small businesses organized as partnerships, limited liability corporations or S- corporations claim as compensation for tax purposes. Current law requires Social Security and Medicare taxes to be levied on all “reasonable compensation” of employees of these pass-through entities. But according to a January JCT options paper, owner-employees have an incentive to under-report their wages to avoid paying excessive payroll taxes. They might take a large chunk of income as a distribution, which would not be subject to those taxes. JCT and the Treasury Department’s Inspector General for Tax Administration have proposed changing the rules to ensure that payroll taxes are levied on all a firm’s income, regardless of how it is counted. Concern in the small business community that Treasury might back a rule change of that nature was heightened when the IRS announced late last month that it was auditing 5,000 S-corporations with an eye toward recommending potential policy changes.
A broad coalition of business groups that includes the National Federation of Independent Business, the National Restaurant Association, National Association of Manufacturers and a number of state chambers of commerce has been formed to lobby against the payroll tax change. The coalition is being coordinated by Reardon of Venn Strategies, which represents the S Corporation Association. Opponents of the JCT proposal claim that the IRS already has the ability to determine whether a taxpayer’s claims of “reasonable compensation” are accurate, and to collect whatever taxes it thinks have gone unpaid. “Our goal is to educate members and educate staff to make sure they understand these are bad policies; they’re bad economics. They would represent a direct, unfair tax on a lot of employers,” said Reardon. But the coalition also faces a unique challenge when communicating the problem to Republican lawmakers in particular: The problem highlighted by JCT was earlier identified by Vice President Cheney in a debate last summer with then-Sen. John Edwards of North Carolina, the Democratic vice-presidential nominee. Cheney raised questions about whether Edwards was avoiding payroll taxes by structuring his law practice as an S-corporation and under- reporting his “reasonable compensation.”
— by Martin Vaughan
August 5th, 2005
Reaction Mixed to IRS Audit Project, But Some See Aid to Compliance Efforts
Practitioner reaction to the Internal Revenue Service’s launch of an ambitious audit project targeting Subchapter S corporations has been mixed, with some puzzled about why such corporations are attracting additional compliance scrutiny. Other practitioners, however, said several compliance problems are more prevalent in S corporations and the project may help address those deficiencies.
IRS announced July 25 it will audit 5,000 randomly selected Subchapter S corporations for tax years 2003 and 2004 in an effort to improve tax law compliance (142 DTR G-1, TaxCore, 7/26/05). The audits are scheduled to begin by the end of 2005.
Higgs, Fletcher & Mack LLP partner and former American Bar Association Section of Taxation Chairman Richard Shaw told BNA Aug. 3 the project could be “very constructive” to enhance taxpayer compliance by the millions of S corporations in existence. While several practitioners could list areas of possible S corporation noncompliance, many also said they were not aware of any egregious, widespread violations currently occurring. Other practitioners noted several compliance problems may be more prevalent in S corporations than with other types of corporate structures.
An IRS spokesman said the audits are not necessarily aimed at targeting specific noncompliant taxpayers; rather, if successful the project will help identify taxpayer trends and practices that will help IRS devote its enforcement resources to areas where they will have the most impact while reducing the number of no-change audits.
Another reason for the examinations is that IRS has not conducted an audit project to identify S corporation compliance issues in more than 20 years, the spokesman said.
Tax Law Changes
In its July 25 announcement, IRS cited the dramatic increase in the use of S corporations as a chief reason the project was launched. IRS said the number of S corporations increased from 724,749 in 1985 to 3,154,377 in 2002. Steptoe & Johnson LLP practitioner Mark Silverman told BNA July 29 the growth in S corporations can be explained, at least in part, by the repeal of the General Utilities doctrine. Prior to 1986, if a corporation sold or distributed assets during its liquidation it did not pay tax on the gain, except recaptured gain, he said.
But due to the implementation of Internal Revenue Code Section 311(b), enacted as part of the repeal of that doctrine, corporations that are not S corporations now have to pay tax on any realized gain when they sell or distribute assets in liquidation.
Many corporations converted to S corporation status as a result of that tax change, which likely contributed to significant S corporation growth after 1985, said Silverman, who leads his firm’s tax practice. Also, Congress has acted to liberalize S corporation rules during the last 10 years to encourage their use, also leading to their popularity as a corporate structure, Silverman and others said.
S Corporation Compliance Issues
Several practitioners said they were not aware of any particular S corporation noncompliance issues currently vexing IRS. “In terms of individual taxpayers, I don’t see any deep abuses that are being conducted through S corporations that cannot be done through other types of entities,” Morgan, Lewis & Bockius LLP associate Daniel Carmody told BNA Aug. 3.
But Ernst & Young LLP tax principal Laura MacDonough noted that S corporation litigation frequently involves a few specific issues, such as unreasonably low compensation levels and the basis for restructured related-party loans. Shaw also listed several compliance issues that involve S corporations which may receive increased attention during the audit project: failure to report employment taxes tied to compensation levels, excessive pass-through of corporation losses to corporate shareholders, and shareholders violating S corporation eligibility rules.
Indeed, closer scrutiny to S corporation eligibility rules may reveal some S corporations have made unintended errors–perhaps years after the error occurred–which technically could cause them to lose their S corporation status and be converted to Subchapter C corporations, said Carmody, a former IRS Office of Chief Counsel senior counsel.
But to date, IRS has been “pragmatic” in limiting its disallowance of S corporation status due to unintended, minor violations, Shaw said.
Second Major NRP Project
The S corporation examination project is the second significant project launched within IRS’s National Research Program. Between October 2002 and September 2004, IRS carried out an audit of approximately 46,000 individual taxpayers in an effort, similar to the S corporation project, to better define the tax gap (60 DTR G-11, TaxCore, 3/30/05). The tax gap is the difference between what IRS is owed in taxes and the amount of tax actually paid in a timely manner. A chief finding of that project was that the tax gap for 2001 alone totaled as much as $350 billion. IRS Office of Research, Analysis and Statistics Director Mark Mazur told reporters March 29 additional and perhaps more refined conclusions of that data will be completed by the end of 2005.
The NRP, launched in 2000, aims to design and implement successful strategies to collect data to use to measure taxpayer payment, filing, and reporting compliance.
By Stephen Joyce