INCREASED S CORP SCRUTINY

INCREASED S CORP SCRUTINY — JULY 28TH, THE HILL

Yesterday’s “The Hill” takes a look at the two challenges facing the S Corp community today- by modernizing S Corp rules to ensure S Corporations continue to thrive, and blocking misguided proposals to apply payroll taxes to all S Corporation income, regardless if that income is due to capital investment or even distributed to shareholders. Full article is attached below.

IRS FOCUSED ON S CORPS: JULY 27th, WALL STREET JOURNAL

Wednesday saw another story in the Wall Street Journal on the IRS’s plan to conduct special audits of 5,000 S Corps over the next couple years. These audits are a follow-up to the preliminary results of the National Research Program study -aka the “Tax Gap” study released in March, and should be a major source of concern to the S Corporation population.

Why just S Corps? Why not C Corps and partnerships? After years of focusing on improving its public image and working more cooperatively with taxpayers, it is obvious the IRS is beginning to focus again on audits and enforcement, with the nation’s S Corp population firmly in the cross hairs. Full article is copied below.

TREASURY RESPONDS TO SENATOR LINCOLN’S INQUIRY: OPPOSES PREMISE OF JCT & TIGTA RECOMMENDATIONS

At last weeks Finance Committee hearing on several pending Treasury nominations, small business champion Senator Blanche Lincoln asked the nominees:

Over the past four years, the Bush Administration has joined Congress in supporting the small business community in a variety of ways, including reducing their tax burden through across-the-board rate relief. More recently, however, the Treasury Department’s Inspector General for Tax Administration (TIGTA) has proposed applying payroll taxes to all the net income of certain S Corporations, even when that income resulted from capital investment. Is the TIGTA’s recommendation the position of the Department of Treasury, and do you believe that subjecting the net earnings of pass-through entities like S corporations to the payroll tax violates the long-standing principle that payroll taxes be applied to wage income?

Here’s the response she received from Treasury:

The Administration believes that amounts received that are not attributable to services should not be subject to employment taxes. However, the Administration is seriously concerned with the size of the employment tax gap. As the Treasury Department’s Inspector General for Tax Administration pointed out in his testimony before the Senate Finance Committee, single-owner S corporations have been designed to shelter personal services from employment taxes, even in cases where the corporation involves little or no capital investment. The Administration shares TIGTA’s additional concern with the impropriety of an S Corporation owner being subject to lower Social Security and Medicare taxes than a sole proprietor or partner in a partnership. In evaluating any legislative proposal to change the law with respect to employment taxation of S corporation shareholders, the Administration will consider these competing principles of equity among business owners and the need to apply employment taxation to compensation for services.

Since both the TIGTA and JCT recommendations would apply payroll taxes to income derived from capital, Treasury’s response indicates they do not support those proposals. That’s good news for S Corps and something to be pursued as this issue develops. More to follow on this front…

Small businesses face unwelcome IRS scrutiny — By Elana Schor, The Hill, July 28, 2005

The IRS plan to audit S corporations for possible tax abuses comes at an awkward time for the popular businesses as they continue to step up their push for a bill to ease their regulatory burdens. S corporation is the nation’s most common corporate tax designation, used by more than 3 million small-business owners who take advantage of the accompanying tax breaks to stimulate their profits. Numerous conglomerates began life as S corporations, including Kinko’s and NASCAR.

The random IRS screening of S-corporation tax returns, in concert with two government proposals this year to start levying payroll taxes on the businesses, has become unwelcome attention as lawmakers work on drafting broad S- corporation legislation.

“It’s politically risky, sure, for the IRS. If they want to go down this road, we don’t want [our businesses] to be stifled based on scare tactics,” said Ryan Peebles, manager of legislative affairs at the National Federation of Independent Business (NFIB).

Sen. Blanche Lincoln (D-Ark.) and Rep. Clay Shaw (R-Fla.) are both sponsors of the most current S-corporation bill, which would make it easier for so-called C corporations (which include most publicly traded firms) to convert to S status. Lincoln and Shaw are planning to introduce a new S-corporation bill soon after the August recess that would address myriad small-business priorities, and lobbyists said the growing public notice of S corporations could turn out to be less of a setback once the bill comes out.

Heidi Blumenthal, a tax lobbyist for the Associated General Contractors (AGC), said that the IRS audit and the payroll-tax debate are “creating focus” on S corporations and that even negative focus is a boon for lobbyists working on such a complex issue. “It’s a jumping-off point for the [Lincoln-Shaw] modernization bill, that has actually been worked on for quite a while. But now people are more ready to talk about it.”

Congress will increase the IRS enforcement budget for next year by as much as 8 percent, empowering the agency to close the $300-billion-plus gap between tax bills and taxes paid in the United States. Cracking down on S corporations, which are prone to tax evasion and sheltering by business owners, could be a huge revenue generator at a time when the growing federal deficit cries out for new money to be generated by busting delinquent taxpayers.

“The use of S corporations has exploded. The IRS needs a better understanding of what this means for tax compliance,” IRS Commissioner Mark Everson said in a statement following the agency’s audit announcement.
Hitting S corporations with Social Security and Medicare payroll taxes also would pad government coffers by $57 billion, as suggested in a January report from the congressional Joint Committee on Taxation and May testimony from J. Russell George, an inspector general at the Treasury Department. Both the report and the testimony alarmed business trade organizations and, despite the negative tone, mobilized S-corporation lobbyists to play good defense.

“You’re starting to get [congressional] staff talking about it, looking at it. That makes it a lot easier for us, in terms of lobbying on the education side,” Blumenthal said. The AGC, the NFIB and the U.S. Chamber of Commerce joined more than 20 other groups in petitioning congressional leadership to condemn publicly the payroll-tax proposal.
Brian Reardon, the top lobbyist at the S Corporation Association, said his goal was to keep the larger legislative changes sought by S corporations separate from the communications challenges posed by the payroll-tax and audit developments.

“It’s two different tracks,” Reardon said. “The modernization effort has its own momentum. The payroll-tax issue is an effort to educate members as to why the proposals on the table are bad policy and going to hurt business creation.”

S-corporation shareholders are currently exempt from payroll taxes because their income from the businesses is not classified as traditional earnings. Only passive income of S-corporation members is taxed, at a rate of 25 percent relative to total income; the coming Lincoln-Shaw bill likely will heed a Joint Committee on Taxation recommendation and hike that number to 60 percent.B Other priorities for S-corporation owners include allowing tax deductions for stock donated to a charitable organization and lifting the ban on nonresident aliens’ serving as shareholders. An S corporation can have no more than 100 shareholders, and strict curbs are in place to prevent individual retirement accounts from buying S- corporation stock.

Peebles said that the NFIB’s S-corporation owners average only five employees and no shareholders and that the “lack of manpower to help out” makes the burden of a random IRS audit “a tremendously frightening experience” for small-business owners.

IRS to Put Focus on S Corporations, Wall Street Journal, July 27, 2005; Page D2

The Internal Revenue Service is planning to conduct special audits of about 5,000 closely held businesses as part of a wide-ranging research program to help combat tax evasion and improve compliance.B These audits, scheduled to begin later this year, will focus on returns filed by a type of business known as an S corporation, IRS officials said this week. With a typical S corporation, the income, losses and deductions flow through directly to shareholders, instead of being taxed at the corporate level.

These corporations “continue to be the single most popular corporate entity choice,” the IRS said, and their total assets are huge. The total number of returns filed by S corporations for the 2002 tax year was nearly 3.2 million, according to an article by Kelly Luttrell, an IRS economist, in the latest issue of the IRS Statistics of Income Bulletin. That was up from about three million in 2001 and about 725,000 in 1985. Total assets rose 7.1% in 2002, to more than $2 trillion.

IRS officials said the S-corporation audits, based on returns for tax years 2003 and 2004, will be the first of their kind in nearly 20 years. The audits will focus on the extent to which income, deductions and credits are reported properly not only by the corporations themselves but also by their owners. The returns will be selected randomly among S corporations of various sizes, an IRS official said yesterday.

“The tax law is so complex that a lot of small-business people have trouble complying,” says Tom Ochsenschlager, vice president of taxation at the American Institute of Certified Public Accountants in Washington.

S corporations, named after a segment of the Internal Revenue Code, can range widely in type of business and asset size, says Daniel A. Shapiro, a tax partner at Berdon LLP, an accounting and advisory firm based in New York City. If your S corporation’s return is selected for audit under this program, “I would be prepared for a more comprehensive examination” than usual, he says.

This project represents another stage in a major IRS research program launched more than five years ago. The project, known as the National Research Program, is designed to help the IRS improve overall compliance and do a better job of selecting which returns to audit. Senior officials say too many audits of individual taxpayers have resulted in no change in the amount of tax owed, thus representing a waste of time and energy for taxpayers and IRS agents.

The IRS’s National Research Program has already analyzed noncompliance among individuals, based on special audits of about 46,000 individual returns randomly selected among various income groups. Preliminary results from that study, announced in late March, suggested that the government still has an enormous amount of work to do in combating cheating. The study indicated tax evasion and other forms of noncompliance are costing the government more than a quarter of a trillion dollars in lost revenue each year.

IRS officials already have taken several major steps to increase enforcement. They have greatly increased audits of high-income individuals and corporations. They have launched a major crackdown on what they call “abusive” shelters, or transactions they say have no real business purpose other than to dodge taxes. And they have intensified scrutiny of tax lawyers, accountants and other professionals.

One group that isn’t happy about the S-corporation audits is the National Federation of Independent Business. “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,” said Dan Danner, the group’s executive vice president.

For a copy of the IRS announcement about plans to audit S corporations, go to the IRS website and look under “The Newsroom.” Or go directly to: http://www.irs.gov/newsroom/article/0,,id=141441,00.html2

The IRS Statistics of Income Bulletin article mentioned in the Tax Report is on the IRS Web site:
http://www.irs.gov/pub/irs-soi/02scorp.pdf3

The IRS reminder about special tax provisions for storm victims can be found on the home page of the IRS Web site4. Or go directly to: http://www.irs.gov/newsroom/article/0,,id=108362,00.html5

The New York State Bar Association tax section letter cited in the Tax Report can be found at this site:
http://www.nysba.org/Content/ContentGroups/Section_Information1/Tax_Section_Reports/1092ltr.pdf6