Tax Gap
Actions Needed to Address Noncompliance with S Corporation Tax Rules Gao ID: GAO-10-195 December 15, 2009S corporations are one of the fastest growing business types, accounting for nearly 4 million businesses in 2006. However, long-standing problems with S corporation compliance produce revenue losses in individual income taxes and employment taxes. GAO was asked to (1) describe the reasons businesses choose to become S corporations, (2) analyze types of S corporation noncompliance, what IRS has done to address noncompliance, and options to improve compliance, and (3) further analyze the extent of shareholder compensation noncompliance and identify options for improving compliance. GAO analyzed IRS research and examination data; interviewed IRS officials, examiners and other knowledgeable stakeholders; and reviewed relevant literature.
An S corporation is a federal business type that provides certain tax and other benefits, including a single level of taxation, limited employment taxes, and the ability to pass through business losses to shareholder returns. Single-level taxation can reduce overall taxes assessed based on business income, and applying business losses to individual returns can decrease shareholder tax obligations. S corporations also benefit from limited liability protection. According to IRS data, about 68 percent of S corporation returns filed for tax years 2003 and 2004 (the years data were available) misreported at least one item. About 80 percent of the time, misreporting provided a tax advantage to the corporation and/or shareholder. The most frequent errors involved deducting ineligible expenses, which could decrease S corporation shareholder tax liabilities. Even though a majority of S corporations used paid preparers, 71 percent of those that did were noncompliant. Stakeholder representatives said that preparer mistakes may be due to the lack of preparer standards as well as their misunderstanding of the tax rules. Shareholders of S corporations also made mistakes in calculating basis - their ownership share of the corporation - when taking losses passed to them from the corporation, potentially decreasing their total taxes. IRS officials as well as stakeholder representatives said that calculating and tracking basis was one of the biggest challenges for shareholders, and that S corporations themselves were in a better position in most cases to calculate basis for their shareholders. Some S corporations also failed to pay adequate wages to shareholders for their labor for the corporation, which led to underpaying employment taxes. Joint Committee on Taxation (JCT) and Treasury Inspector General for Tax Administration (TIGTA) reports show that inadequate shareholder wage compensation is a significant issue. Using IRS data, GAO calculated that in the 2003 and 2004 tax years, the net shareholder compensation underreporting equaled roughly $23.6 billion, which could result in billions in annual employment tax underpayments. Stakeholder representatives, IRS officials, and TIGTA have indicated that determining adequate shareholder compensation is highly subjective and hinders compliance and enforcement. IRS provides limited guidance on determining adequate compensation. Stakeholder representatives indicated that specific IRS guidance for both new and existing S corporations could help improve compliance. Additionally, IRS examiners often were not taking advantage of certain techniques in examining shareholder compensation. Analyzing a random sample of IRS examinations, GAO found that in cases where IRS examiners did document a form of analysis, they were more likely to make an adjustment than when no evidence of such analysis existed. Currently, IRS does not require specific documentation of their analysis for shareholder compensation by examiners. Legislative options exist to improve compliance with shareholder compensation rules; however, these options also raise notable trade-offs.
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Report to the Committee on Finance, U.S. Senate:
United States Government Accountability Office:
GAO:
December 2009:
Tax Gap:
Actions Needed to Address Noncompliance with S Corporation Tax Rules:
GAO-10-195:
GAO Highlights:
Highlights of GAO-10-195, a report to the Committee on Finance, U.S.
Senate.
Why GAO Did This Study:
S corporations are one of the fastest growing business types,
accounting for nearly 4 million businesses in 2006. However, long-
standing problems with S corporation compliance produce revenue losses
in individual income taxes and employment taxes. GAO was asked to (1)
describe the reasons businesses choose to become S corporations, (2)
analyze types of S corporation noncompliance, what IRS has done to
address noncompliance, and options to improve compliance, and (3)
further analyze the extent of shareholder compensation noncompliance
and identify options for improving compliance. GAO analyzed IRS
research and examination data; interviewed IRS officials, examiners and
other knowledgeable stakeholders; and reviewed relevant literature.
What GAO Found:
An S corporation is a federal business type that provides certain tax
and other benefits, including a single level of taxation, limited
employment taxes, and the ability to pass through business losses to
shareholder returns. Single-level taxation can reduce overall taxes
assessed based on business income, and applying business losses to
individual returns can decrease shareholder tax obligations. S
corporations also benefit from limited liability protection.
According to IRS data, about 68 percent of S corporation returns filed
for tax years 2003 and 2004 (the years data were available) misreported
at least one item. About 80 percent of the time, misreporting provided
a tax advantage to the corporation and/or shareholder. The most
frequent errors involved deducting ineligible expenses, which could
decrease S corporation shareholder tax liabilities. Even though a
majority of S corporations used paid preparers, 71 percent of those
that did were noncompliant. Stakeholder representatives said that
preparer mistakes may be due to the lack of preparer standards as well
as their misunderstanding of the tax rules. Shareholders of S
corporations also made mistakes in calculating basis – their ownership
share of the corporation – when taking losses passed to them from the
corporation, potentially decreasing their total taxes. IRS officials as
well as stakeholder representatives said that calculating and tracking
basis was one of the biggest challenges for shareholders, and that S
corporations themselves were in a better position in most cases to
calculate basis for their shareholders.
Some S corporations also failed to pay adequate wages to shareholders
for their labor for the corporation, which led to underpaying
employment taxes. Joint Committee on Taxation (JCT) and Treasury
Inspector General for Tax Administration (TIGTA) reports show that
inadequate shareholder wage compensation is a significant issue. Using
IRS data, GAO calculated that in the 2003 and 2004 tax years, the net
shareholder compensation underreporting equaled roughly $23.6 billion,
which could result in billions in annual employment tax underpayments.
Stakeholder representatives, IRS officials, and TIGTA have indicated
that determining adequate shareholder compensation is highly subjective
and hinders compliance and enforcement. IRS provides limited guidance
on determining adequate compensation. Stakeholder representatives
indicated that specific IRS guidance for both new and existing S
corporations could help improve compliance. Additionally, IRS examiners
often were not taking advantage of certain techniques in examining
shareholder compensation. Analyzing a random sample of IRS
examinations, GAO found that in cases where IRS examiners did document
a form of analysis, they were more likely to make an adjustment than
when no evidence of such analysis existed. Currently, IRS does not
require specific documentation of their analysis for shareholder
compensation by examiners. Legislative options exist to improve
compliance with shareholder compensation rules; however, these options
also raise notable trade-offs.
What GAO Recommends:
Congress should require S corporations to calculate and report basis
for their shareholders‘ ownership shares.
GAO also recommends that IRS research options for improving the
performance of professional tax preparers, provide additional guidance
to new S corporations on calculating basis and compensation, require
examiners to document analysis of compensation, and provide more
guidance on compensation.
In commenting on a draft of this report, IRS generally agreed with our
recommendations.
View [hyperlink, http://www.gao.gov/products/GAO-10-195] or key
components. For more information, contact Mike Brostek at (202) 512-
9110 or brostekm@gao.gov.
[End of section]
Contents:
Letter:
Background:
S Corporations Provide Certain Tax-Related and Other Advantages:
In Tax Years 2003 and 2004, a Majority of S Corporations Were
Noncompliant with at Least One Tax Rule; Various Options Exist to
Address Noncompliance:
Inadequate Wage Compensation to S Corporation Shareholders Creates
Employment Tax Noncompliance, Which Could be Addressed through
Legislative or Administrative Changes:
Conclusions:
Matter for Congressional Consideration:
Recommendations:
Agency Comments:
Appendix I: Scope and Methodology:
Appendix II: Trends in the Growth of S Corporations:
Appendix III: Analysis of S Corporation Losses:
Appendix IV: Comments from the Internal Revenue Service:
Appendix V: GAO Contact and Staff Acknowledgments:
Tables:
Table 1: Important Tax Considerations by Business Entity Type:
Table 2: Most Common Misreported Line Items by Number of S Corporations
Misreporting and Amounts Misreported (Absolute Dollar Values), Tax
Years 2003 and 2004 Combined:
Table 3: Percentage of S Corporations Underreporting and Overreporting
Common Line Items, Tax Years 2003 and 2004 Combined:
Table 4: Percentage of S Corporations Misreporting Common Line Items by
Number of Shareholders, Tax Years 2003 and 2004 Combined:
Table 5: Type of Misreporting by S Corporations, Tax Years 2003 and
2004 Combined:
Table 6: Options for Improving Compliance with S Corporation Rules:
Table 7: Estimated Number of S Corporation Examinations with
Shareholder Compensation Issues, Examinations Closed in Fiscal Years
2006 to 2008:
Table 8: Legislative Options to Address Shareholder Compensation:
Table 9: Identified Pros and Cons of Basing Employment Tax Liability
For Shareholders on the Net Business Income Reported by S Corporations:
Table 10: Identified Pros and Cons of Basing Employment Tax Liability
on All Types of Payments Made to Active Shareholders:
Table 11: S Corporations Taking Ordinary Losses in Multiple Years, Tax
Years 2001 to 2006:
Table 12: S Corporations Taking Ordinary Losses in Consecutive Years,
Tax Years 2001 to 2006:
Table 13: S Corporation Ordinary Losses, Tax Years 2001 to 2006, for S
Corporations that Took Losses in 2003:
Table 14: Total and Median Ordinary Losses Claimed by S Corporation
Shareholders, Tax Year 2001:
Table 15: Percentage of Non-S-Corporation Income Offset by S
Corporation Losses, Tax Year 2001:
Figures:
Figure 1: Total S Corporation Assets, Net Income, Gross Business
Receipts, and Deductions, Tax Years 2000 to 2006:
Figure 2: Net Value of Adjustments for Shareholder Compensation in
Billions, by Number of Shareholders, Tax Years 2003 and 2004:
Figure 3: Number of Businesses by Business Type, Tax Years 2000 to
2006:
Figure 4: Share of Total Net Income, Business Receipts, Deductions, and
Assets by Number of Shareholders, Tax Year 2006:
Figure 5: Newly Elected S Corporations, Tax Years 2000 to 2006:
Figure 6: S Corporation Loss Taking By Number of Shareholders, Tax Year
2006:
[End of section]
United States Government Accountability Office:
Washington, DC 20548:
December 15, 2009:
The Honorable Max Baucus:
Chairman:
The Honorable Charles Grassley:
Ranking Member:
Committee on Finance:
United States Senate:
S corporations have been one of the fastest growing business entity
types in recent years, displaying the second largest percentage
increase among federal business types from tax year 2000 to 2006, next
to partnerships.[Footnote 1] In 2006, nearly 4 million S corporations
accounted for $3.3 trillion in total assets as well as $413 billion in
total net income.[Footnote 2] The S corporation entity type provides
limited liability protection[Footnote 3] to shareholders,[Footnote 4]
and S corporations "pass through" gains and losses to shareholders'
individual tax returns without generally paying taxes at the entity
level.
In addition, if S corporations are not compliant with tax requirements,
income, losses, and deductions passed through to the shareholders will
be inaccurate, resulting in noncompliance on their individual income
taxes. The Internal Revenue Service (IRS) does not have an estimate of
tax losses due to S corporation noncompliance. IRS has estimated that
income tax revenue losses due to pass-through entities' noncompliance,
including S corporations, totaled $22 billion for tax year 2001, which
is IRS's most recent estimate. In addition, employment tax revenue
losses due to noncompliance with tax rules were estimated to be $15
billion for all types of entities (including S corporations) in 2001.
For example, S corporations must pay employment taxes on wage
compensation paid to officers and employees. S corporations may be
tempted to pay shareholder-employees an inadequate wage and higher
distribution[Footnote 5] to avoid employment tax liabilities.
Due to the growth in S corporations and concerns about its tax losses,
you asked us to examine noncompliance with S corporation tax rules.
This report (1) describes reasons a business might choose to become an
S corporation; (2) analyzes types of S corporation noncompliance, what
the IRS has done to address noncompliance overall, and options to
improve compliance; and (3) further analyzes the extent of
noncompliance involving a long standing concern over inadequate
shareholder compensation, and identifies options for improving
compliance.
To describe reasons for a business to choose S corporation status, we
reviewed relevant literature and interviewed IRS officials. We
interviewed over 40 stakeholder representatives of nine industry and
professional organizations, including small business associations, tax
preparer groups, and legal professionals. Using the information
gathered from these sources, we determined tax and nontax
considerations that might motivate business owners to elect S
corporation status over the other business entity types. To analyze
types of S corporation noncompliance, we used data from S Corporation
National Research Program (NRP) samples drawn for tax years 2003 as
well as for 2004.[Footnote 6] We also reviewed a random,
nongeneralizable sample of 166 cases from the 2003 and 2004 S
Corporation NRP for insights on the noncompliance. To determine what
IRS has done to address noncompliance and options for improvement, we
analyzed IRS examination data from its Examination Operational
Automated Database (EOAD) for fiscal years 2006 to 2008. In addition,
we interviewed IRS officials, including groups of IRS examiners, and
the industry representatives mentioned above, and collected information
from IRS on its enforcement and service programs. To further analyze
the extent of noncompliance in reporting shareholder compensation, we
used data from the S Corporation NRP. To determine options for
improving compliance on shareholder compensation, we reviewed relevant
studies and articles and interviewed the IRS officials and stakeholder
representatives mentioned above. All percentage estimates in this
report have 95 percent confidence intervals that are within +/-8
percentage points of the estimate itself, unless otherwise specified.
All other estimates in this have 95 percent confidence intervals that
are within +/-10 percent value of the estimate itself, unless otherwise
specified. We determined for the purposes of this review that the data
used were reliable. When possible, we compared published results with
self-generated analyses. (See appendix I for further discussion of our
scope and methodology.) We conducted this performance audit from May
2007 to October 2009 in accordance with generally accepted government
auditing standards. Those standards require that we plan and perform
the audit to obtain sufficient, appropriate evidence to provide a
reasonable basis for our findings and conclusions based on our audit
objectives. We believe that the evidence obtained provides a reasonable
basis for our findings and conclusions based on our audit objectives.
Background:
S corporations are a common and growing business type. For federal tax
purposes, businesses generally operate as S corporations, C
corporations, partnerships, or sole proprietorships. According to the
most recent IRS data available, the number of S corporations grew by 35
percent from tax year 2000 to 2006, for a total of nearly 4 million
businesses in 2006. S corporations have also grown as a proportion of
all businesses, from 11.4 percent of all entities in tax year 2000 to
12.6 percent in tax year 2006. In 2006, they were the second most
common entity type after sole proprietorships.
S corporations' assets and total net income also demonstrate their
economic significance. From tax years 2000 to 2006, S corporations'
total net income[Footnote 7] grew by 67 percent, or $166 billion, and
their total assets grew by 46 percent, or $1.0 trillion.[Footnote 8]
Gross business receipts and deductions also increased substantially in
this time period. Figure 1 shows total S corporation assets, net
income, gross business receipts, and deductions in tax years 2000 to
2006.
Figure 1: Total S Corporation Assets, Net Income, Gross Business
Receipts, and Deductions, Tax Years 2000 to 2006:
[Refer to PDF for image: vertical bar graph]
Tax year: 2000;
Assets: $2.2 trillion;
Net income: $0.2 trillion;
Gross business receipts: $4.4 trillion;
Deductions: $4.3 trillion.
Tax year: 2001;
Assets: $2.3 trillion;
Net income: $0.2 trillion;
Gross business receipts: $4.5 trillion;
Deductions: $4.4 trillion.
Tax year: 2002;
Assets: $2.4 trillion;
Net income: $0.2 trillion;
Gross business receipts: $4.6 trillion;
Deductions: $4.5 trillion.
Tax year: 2003;
Assets: $2.6 trillion;
Net income: $0.3 trillion;
Gross business receipts: $4.9 trillion;
Deductions: $4.8 trillion.
Tax year: 2004;
Assets: $2.8 trillion;
Net income: $0.3 trillion;
Gross business receipts: $5.3 trillion;
Deductions: $5.2 trillion.
Tax year: 2005;
Assets: $3 trillion;
Net income: $0.4 trillion;
Gross business receipts: $5.7 trillion;
Deductions: $5.5 trillion.
Tax year: 2006;
Assets: $3.3 trillion;
Net income: $0.4 trillion;
Gross business receipts: $6.1 trillion;
Deductions: $5.9 trillion.
Source: GAO analysis of IRS‘s SOI data.
[End of figure]
Most S corporations are held by three or fewer shareholders. In tax
year 2006, 60 percent of S corporations had a single shareholder, 89
percent had two or fewer shareholders, and 94 percent had three or
fewer shareholders. S corporations held by three or fewer shareholders
accounted for the majority of the net income, gross receipts,
deductions, and assets for S corporations in 2006, and those held by a
single shareholder accounted for over 30 percent of these items.
Conversions of C corporations to S corporations have contributed to the
growth in numbers of S corporations; between 78,000 to 97,000 C
corporations converted to S corporations per year from tax years 2000
to 2006,[Footnote 9] representing 23 to 31 percent of new S
corporations each year.[Footnote 10] Appendix II provides additional
details on trends in the growth, size, and characteristics of S
corporations.
Reporting Rules:
S corporations are small business corporations that file an election
form (Form 2553, Election by a Small Business Corporation) that allows
them to be taxed under subchapter S of the income tax section of the
Internal Revenue Code. They must meet the following requirements to be
recognized as an S corporation:
* be a domestic corporation;
* have only eligible shareholders, which include individuals, estates,
certain trusts, and certain tax-exempt organizations, but not
partnerships, corporations, or nonresident aliens;
* have no more than 100 shareholders (multiple members of a family may
count as a single shareholder for this purpose); and:
* have only one class of stock.[Footnote 11]
S corporations file Form 1120S (U.S. Income Tax Return for an S
Corporation) to report their business income, losses, and other items
related to federal tax laws. S corporations are also required to
provide their shareholders and IRS with a Schedule K-1 (Shareholder's
Share of Income, Deductions, Credits, Etc.) to report information on
the allocation of income, losses, and other items. Using the K-1
information, shareholders of S corporations report their pass-through
ordinary income or losses on Part II of Schedule E (Supplemental Income
and Loss), which most shareholders are to attach to the individual
income tax return, Form 1040.[Footnote 12] Other separately stated
items of income, loss, or deductions are reported on various other Form
1040 schedules. For example, interest income is reported on the
shareholder's Form 1040, Schedule B and a capital gain or loss is
reported on the shareholder's Form 1040, Schedule D.
Basis:
A shareholder can claim S corporation losses and deductions to offset
other income earned by the individual shareholder. However, the
shareholders generally can only claim losses and deductions up to the
amount of basis the shareholder has in the S corporation's stock and
debt.[Footnote 13] Stock basis begins with the shareholder's initial
capital contribution to the S corporation or the initial cost of the
stock purchased. That amount may increase or decrease each year. An
income item will increase stock basis; a loss, deduction or non-
dividend distribution will decrease stock basis, based on certain
ordering rules. For losses and deductions that exceed a shareholder's
stock basis, the shareholder is allowed to deduct the excess up to the
shareholder's debt basis, which is created by loans that the
shareholder personally made to the S corporation.
Employment Tax:
Like any employer, S corporations must pay and withhold for employment
taxes on wages.[Footnote 14] Unlike partnerships and sole
proprietorships, S corporations can pay both wages and distributions to
shareholders, but only wages are subject to employment taxes. IRS
requires that S corporations pay a reasonable compensation (or wage) to
shareholders who perform services for the S corporation.[Footnote 15]
S Corporations Provide Certain Tax-Related and Other Advantages:
A single level of taxation, the ability to pass through business losses
to shareholders, and calculating employment taxes on wages rather than
net business income are the most significant tax-related reasons that
business owners elect treatment as an S corporation. While S
corporations share each of these characteristics with other business
types, it is the only business type with all three of these
characteristics, as shown in table 1.
Table 1: Important Tax Considerations by Business Entity Type:
Levels of taxation:
S corporation: Business income is taxed at the individual tax rate
(single level);
C corporation: Business income is taxed at the corporate tax rate and,
if distributed, at the individual dividend tax rate (double taxation);
Partnership: Business income is taxed at the individual tax rate
(single level);
Sole proprietorship: Business income is taxed at the individual tax
rate (single level).
Treatment of business losses[A]:
S corporation: Business losses pass through to the individual income
tax return and can offset other income;
C corporation: Business losses do not pass through, but can offset
business income on the corporate return;
Partnership: Business losses pass through to the individual income tax
return and can offset other income;
Sole proprietorship: Business losses pass through to the individual
income tax return and can offset other income.
Employment taxes:
S corporation: Employment taxes are assessed on wages;
C corporation: Employment taxes are assessed on wages;
Partnership: All net income of general partners is subject to self-
employment tax;
Sole proprietorship: All net income is subject to self-employment tax.
Source: GAO analysis.
[A] Various limitations on deducting losses exist for each entity type.
S corporation shareholders' abilities to take losses tend to be more
limited than owners of partnerships.
[End of table]
S corporation income is generally subject to a single level of
taxation, which for many owners means lower total taxes compared to a
similarly profitable C corporation. As pass-through entities, S
corporations list their net business income and losses on the Form
1120S but are not generally taxed at the entity level; income, losses
and deduction items pass through to the individual shareholders' income
tax returns, and the individuals are taxed on any net income. Owners of
partnerships and sole proprietorships are also taxed only on their
business income at the individual level. In contrast, C corporations
are subject to double taxation: the corporation is taxed on its net
business income, and individual shareholders are also taxed on dividend
income received from the business.
Being able to offset income on the individual income tax returns with S
corporation losses and deductions can be an important consideration for
shareholders who expect and want to obtain tax benefits on those losses
and deductions. For some perspective on the possible significance of
this advantage, we analyzed loss and gain patterns in 2001 to 2006 for
S corporations that took losses in 2003. We found that S corporations
that took losses in 2003 tended to take losses in other years as well.
Of the S corporations in the SOI corporate sample that took losses in
2003 and filed tax returns in each year from 2001 through 2006, 61
percent took losses in 4 or more of the 6 years. Additionally, 51
percent took losses in 4 or more consecutive years.
To gain perspective on the degree to which shareholders use S
corporation losses to offset their other income, we analyzed NRP data
on shareholders' 2001 Form 1040s. On average, shareholders using losses
from S corporations in 2001 offset an estimated 16.6 percent of their
other income with S corporation losses.[Footnote 16] We estimate that
42 percent of the S corporation shareholders used a loss from an S
corporation to offset other income reported on the Form 1040. Many of
these shareholders were shareholders of multiple S corporations. Of the
shareholders reporting S corporation losses, we estimated that 11
percent reported losses from multiple S corporations, and 29 percent
reported income from one or more other S corporations. Appendix III
provides analysis on S corporation losses.
S corporation shareholders can also take advantage of losses through
business networks; for example, a shareholder of two S corporations can
offset income from one S corporation on her individual tax return by
taking a loss from the other S corporation. Owners of partnerships and
sole proprietorships benefit from taking losses on their individual
returns as well. C corporation shareholders, in contrast, cannot
directly benefit from their business's losses, since they are taken at
the corporate level.
S corporation owners also may prefer the entity's possible lower
employment tax burdens compared to partnerships and sole
proprietorships. An S corporation pays employment taxes only on wages
paid to employees, as do C corporations. For officers and other
shareholders who perform services for the corporation, the S
corporation is to treat them as employees, determining and paying them
an adequate wage, referred to as "reasonable compensation."
Shareholders can also receive nonwage distributions that are not
subject to employment taxes. By comparison, general partners of
partnerships and owners of sole proprietorships generally pay self-
employment taxes on the net earnings of the business rather than on
wages earned.[Footnote 17]
Limited Liability Protection and Other Nontax Benefits Are Also
Considerations When Choosing S Corporations:
As for nontax advantages, limited liability protection was frequently
cited by stakeholder representatives we interviewed as a compelling
reason for making a business an S corporation. Corporate status
provides limited liability protection.[Footnote 18]
Less influential nontax reasons for choosing an S corporation that were
mentioned by stakeholder representatives are corporate image,
eligibility for certain government contracts, and the relative
simplicity of the business form. Several representatives mentioned that
corporations project a more professional image than other entity types,
which can be an advantage in getting business. Corporate status is
required for eligibility for certain government contracts, making the S
corporation a good choice for smaller businesses that want to compete
for those contracts. Several stakeholder representatives mentioned the
relative simplicity of the S corporation form, in terms of ease of
formation, ease of operation, and established case law relative to
various other entity types; however, other representatives did not
agree that this was a significant reason for choosing the S corporation
entity type.
Tax Law Changes May Have Spurred S Corporation Growth:
Before 1986, the highest individual tax rate was higher than the
highest corporate tax rate; the Tax Reform Act of 1986[Footnote 19]
reversed this for the next seven years (it was reversed again in 1993),
expanding the appeal of S corporations, whose shareholders pay their
taxes at the individual level. The Small Business Job Protection Act of
1996[Footnote 20] eased several restrictions on S corporations,
including increasing the maximum number of shareholders from 35 to 75
and expanding the type of entities that may be S corporation
shareholders. These and numerous other changes by these two laws to the
S corporation tax rules enhanced the appeal of S corporation status. S
corporations represented less than 6 percent of all businesses in 1986,
but their share increased substantially in the years following the
passage of these two laws, reaching about 12 percent in 2002.
The American Jobs Creation Act of 2004[Footnote 21] further increased
the maximum number of shareholders to 100.
In Tax Years 2003 and 2004, a Majority of S Corporations Were
Noncompliant with at Least One Tax Rule; Various Options Exist to
Address Noncompliance:
According to the NRP, an estimated 68 percent[Footnote 22] of S
corporation returns filed for tax years 2003 and 2004[Footnote 23]
misreported at least one item affecting net income.[Footnote 24] For
those years, the overall net misreported amount--accounting for both
overreported and underreported amounts--that S corporations passed
through to individual shareholders was about $85 billion.[Footnote 25]
For context, assuming that the lowest individual income tax rate of 10
percent applied to this entire misreported amount, $8.5 billion in lost
tax revenues for tax years 2003 through 2004 could have been
attributable to S corporation noncompliance. However, this represents a
highly simplified calculation that is intended solely to illustrate the
potential tax impact at the shareholder level from S corporation
noncompliance.[Footnote 26]
S corporations varied in the items that they misreported. Beyond net
income,[Footnote 27] the most frequently misreported line item was
"other deductions,"[Footnote 28] and among the line items with the
largest misreported amounts were distributions and gross sales. By
median misreported amount, noncompliance was the highest in not paying
the correct wage compensation to S corporation shareholders; this
noncompliance was much greater than the second highest median
misreported amount--distributions to S corporation shareholders. Table
2 identifies the most frequent items that S corporations misreported as
well as the amounts misreported (in absolute values).
Table 2: Most Common Misreported Line Items by Number of S Corporations
Misreporting and Amounts Misreported (Absolute Dollar Values), Tax
Years 2003 and 2004 Combined:
Misreported line items: Net income[A];
Number misreported (in thousands): 4,542;
Net misreported amount (in billions): $84.8[C];
Median misreported amount: $5,459[D].
Misreported line items: Other deductions[B];
Number misreported (in thousands): 3,532;
Net misreported amount (in billions): $37.2[C];
Median misreported amount: $4,204[D].
Misreported line items: Distributions[I];
Number misreported (in thousands): 1,852;
Net misreported amount (in billions): $61.8[H];
Median misreported amount: $7,411[F].
Misreported line items: Gross receipts or sales;
Number misreported (in thousands): 1,508;
Net misreported amount (in billions): $25.8[H];
Median misreported amount: $3,988[G].
Misreported line items: Cost of goods sold;
Number misreported (in thousands): 1,311;
Net misreported amount (in billions): [E];
Median misreported amount: $3,003[G].
Misreported line items: Depreciation expense;
Number misreported (in thousands): 1,000[C];
Net misreported amount (in billions): $5.7[H];
Median misreported amount: $1,755[F].
Misreported line items: Shareholder compensation;
Number misreported (in thousands): 887[C];
Net misreported amount (in billions): $23.6[D];
Median misreported amount: $20,127[D].
Misreported line items: Purchases;
Number misreported (in thousands): 801[C];
Net misreported amount (in billions): [E];
Median misreported amount: $2,031[H].
Misreported line items: Taxes and license expense;
Number misreported (in thousands): 651[C];
Net misreported amount (in billions): $1.4[G];
Median misreported amount: $271[H].
Misreported line items: Repairs and maintenance expense;
Number misreported (in thousands): 585[C];
Net misreported amount (in billions): $2.8[G];
Median misreported amount: $1,505[G].
Misreported line items: Interest expense;
Number misreported (in thousands): 574[C];
Net misreported amount (in billions): $2.3[G];
Median misreported amount: $985[H].
Source: GAO analysis of IRS's NRP data.
Note: All data in this table are 2-year data (total over tax years 2003
and 2004). Estimates in the table have a margin of error within +/-10
percent of the reported value unless otherwise specified.
[A] Misreported net income includes both overstated and understated
income items and deductions. As a result, some items will increase the
net income amount and others will decrease it.
[B] Other deductions include amortization; certain business costs;
insurance premiums; legal and professional fees; supplies; travel,
meal, and entertainment; and utilities.
[C] Estimate is within +/-16 percent of the reported value.
[D] Estimate is within +/-18 percent of the reported value.
[E] Margin of error was too large to generate a reliable estimate.
[F] Estimate is within +/-30 percent of the reported value.
[G] Estimate is within +/-41 percent of the reported value.
[H] Estimate is within +/-89 percent of the reported value.
[I] Distributions do not affect S corporation net income.
[End of table]
The direction of misreporting provided tax advantages for the S
corporations or their shareholders. Overall, of noncompliant S
corporations, about 80 percent underreported net income by understating
income received and/or overstating expenses deducted. For example, as
shown in table 3, 88 percent of the misreporting of repairs and
maintenance involved overstating these expense deductions, resulting in
understated net income. For shareholder compensation, understating
rather than overstating the expense deduction provides the tax
advantage because lower wage compensation means paying less in
employment taxes. Of S corporations that misreported shareholder
compensation, 93 percent understated it.[Footnote 29]
Table 3: Percentage of S Corporations Underreporting and Overreporting
Common Line Items, Tax Years 2003 and 2004 Combined:
Misreported line items: Gross receipts or sales;
Percentage understated income: 80;
Percentage overstated income: 20.
Misreported line items: Other deductions[A];
Percentage understated deductions 91;
Percentage overstated deductions: 9.
Misreported line items: Cost of goods sold;
Percentage understated deductions: 72;
Percentage overstated deductions: 28.
Misreported line items: Depreciation expense;
Percentage understated deductions: 72;
Percentage overstated deductions: 28.
Misreported line items: Shareholder compensation[B];
Percentage understated deductions: 7;
Percentage overstated deductions: 93.
Misreported line items: Purchases;
Percentage understated deductions: 67;
Percentage overstated deductions: 33.
Misreported line items: Taxes and license expense;
Percentage understated deductions: 70;
Percentage overstated deductions: 30.
Misreported line items: Repairs and maintenance expense;
Percentage understated deductions: 88;
Percentage overstated deductions: 12.
Misreported line items: Interest expense;
Percentage understated deductions: 81;
Percentage overstated deductions: 19.
Source: GAO analysis of IRS's NRP data.
Notes: All data in this table are 2-year data (total over tax years
2003 and 2004). All estimates in the table have a margin of error
within +/-8 percentage points. We excluded the distributions line item
because it may not have a tax impact. In general, distributions
received by a shareholder are tax-free up to the shareholder's stock
basis.
[A] Other deductions include amortization; certain business costs;
insurance premiums; legal and professional fees; supplies; travel,
meal, and entertainment; and utilities.
[B] Understating compensation generally results in underpayment of
employment taxes.
[End of table]
Although S corporation shareholders legitimately can offset other
income on their individual income tax returns with S corporation
losses, some shareholders may be claiming S corporation losses that are
not valid. For tax years 2003 and 2004, IRS's NRP examiners raised
adjustments to correct the misreported items on the Form 1120S, which
caused some S corporations initially reporting a net loss to have net
income. As a result, an estimated 13 percent of S corporations claiming
net losses changed to net income after examination, compared to 2
percent that changed from net income to losses. We did not have data to
trace through how the individual tax liabilities of shareholders would
change for those who had used S corporation losses to offset other
income when they actually should be adding the S corporation income to
their other income on their Form 1040.[Footnote 30]
Misreporting differed by the number of shareholders, as shown in table
4. For example, a higher percentage of single shareholder S
corporations misreported other deductions compared to those with four
or more shareholders.
Table 4: Percentage of S Corporations Misreporting Common Line Items by
Number of Shareholders, Tax Years 2003 and 2004 Combined:
Misreported line item: Net income;
1 shareholder: 72%;
2-3 shareholders: 63%;
4 or more shareholders: 53%.
Misreported line item: Other deductions[A];
1 shareholder: 57%;
2-3 shareholders: 48%;
4 or more shareholders: 34%.
Misreported line item: Distributions;
1 shareholder: 30%;
2-3 shareholders: 25%;
4 or more shareholders: 15%.
Misreported line item: Gross receipts or sales;
1 shareholder: 26%;
2-3 shareholders: 18%;
4 or more shareholders: 11%.
Misreported line item: Cost of goods sold;
1 shareholder: 20%;
2-3 shareholders: 20%;
4 or more shareholders: 11%.
Misreported line item: Depreciation expense;
1 shareholder: 16%;
2-3 shareholders: 13%;
4 or more shareholders: 8%.
Misreported line item: Shareholder compensation[B];
1 shareholder: 15%;
2-3 shareholders: 10%;
4 or more shareholders: 4%.
Misreported line item: Purchases;
1 shareholder: 20%;
2-3 shareholders: 18%;
4 or more shareholders: 11%.
Misreported line item: Taxes and license expense;
1 shareholder: 11%;
2-3 shareholders: 8%;
4 or more shareholders: 6%.
Misreported line item: Repairs and maintenance expense;
1 shareholder: 9%;
2-3 shareholders: 9%;
4 or more shareholders: 6%.
Misreported line item: Interest expense;
1 shareholder: 8%;
2-3 shareholders: 9%;
4 or more shareholders: 6%.
Source: GAO analysis of IRS's NRP data.
Notes: All data in this table is 2-year data (total over tax years 2003
and 2004). All estimates in the table have a margin of error within +/-
8 percentage points.
[A] Other deductions include amortization; certain business costs;
insurance premiums; legal and professional fees; supplies; travel,
meal, and entertainment; and utilities.
[B] Understating compensation generally results in underpayment of
employment taxes.
[End of table]
Misreporting varied according to the size of S corporations as measured
by assets. For example, a higher percentage of S corporations with
assets under $250,000 had at least one adjustment than those with $1
million to $10 million in assets.[Footnote 31] Those with assets under
$250,000 represented 79 percent of all S corporations in the sample.
The S corporation NRP provided an avenue to evaluate noncompliance in
misreporting certain line items on the 1120S. As shown in table 5, our
review of 166 randomly selected S corporation returns for tax years
2003 and 2004 that IRS examined under NRP identified some types of
misreporting.
Table 5: Type of Misreporting by S Corporations, Tax Years 2003 and
2004 Combined:
Type of misreporting: Deducted personal expenses;
Number of S corporations: 69;
Number of errors: 169.
Type of misreporting: Did not substantiate the deducted expense;
Number of S corporations: 52;
Number of errors: 122.
Type of misreporting: Deducted expense disallowed for other reasons[A];
Number of S corporations: 61;
Number of errors: 101.
Type of misreporting: Did not claim all allowable expenses;
Number of S corporations: 41;
Number of errors: 64.
Source: GAO analysis of 166 randomly selected NRP examinations.
Note: Some S corporations misreported multiple times. For example, an S
corporation could have deducted expenses without substantiation more
than once throughout the tax return.
[A] Other reasons included deducting an expense paid by an external
party, deducting toll violation, and deducting more than allowable
gifts.
[End of table]
The most common type of misreporting was improperly deducting personal
expenses as business expenses. Of the 166 examination files reviewed,
we found 69 returns that erroneously deducted one or more personal
expenses, resulting in 169 total errors.[Footnote 32] These improper
deductions included payments for personal taxes, personal tax
preparation, personal insurance, personal vehicles, and other personal
expenses. Automobile, insurance, telephone, and travel expenses were
the most commonly misreported personal expenses; for example, we saw
cases in which taxpayers improperly claimed a personal car insurance
expense deduction on the Form 1120S.
The second most common type of misreporting on S corporation tax
returns we reviewed was not adequately substantiating the expenses.
According to stakeholder representatives in the S corporation industry,
S corporations may have neither good bookkeeping nor tax professionals
that advised them about the importance of bookkeeping under complex S
corporation tax rules. These representatives also said that new S
corporations may not have consulted a tax specialist when deciding to
elect S corporation status, and may not be educated about S corporation
tax filing requirements. Another representative told us that some
taxpayers may not be doing bookkeeping for tax purposes until they file
the 1120S, at which time it becomes a challenge for a preparer to sort
out the records and help taxpayers file their return.
S corporations may need a preparer to help them navigate the complex
tax rules to remain in compliance. However, paid preparers make
mistakes too. IRS's NRP results for 2003 to 2004 showed that 81 percent
of the S corporations used a paid preparer. Differences in estimated
noncompliance were not statistically significant comparing whether or
not a paid preparer was involved in preparing the Forms 1120S. We
estimated that 75 percent of the S corporations that did not use a paid
preparer were noncompliant while 71 percent of those that used a paid
preparer were noncompliant.
To some degree, preparers may contribute directly to S corporation
noncompliance. IRS examiners sometimes added notes to the NRP
examination files that attributed the noncompliance to mistakes by
preparers. For example, in the NRP examination files we reviewed, we
found notes that attributed 21 misreported items in 14 files directly
to mistakes by preparers. We do not know to what extent preparers
contributed to the noncompliance in the other NRP cases absent some
indication from IRS's examiners in the case files. On one hand,
stakeholder representatives told us that some preparers may innocently
make mistakes because the S corporation does not provide them with full
and accurate information and records when preparing the Form 1120S. On
the other hand, representatives said that some preparers may not be
sufficiently trained to prepare S corporation returns. Also, the
preparer for the S corporation and individual shareholder returns may
be different. IRS officials said that when the preparer for the S
corporation differs from that used by the shareholders, it may be
challenging to resolve issues that carry across from the entity to the
shareholder.
Properly Calculating Basis Is a Challenge for S Corporation
Shareholders:
In addition to S corporation noncompliance, their shareholders may make
errors related to the S corporation. One type of noncompliance occurs
when a shareholder uses the S corporation losses beyond their allowable
stock and debt basis. Since one advantage of choosing S corporation
status is the ability to offset other income with S corporation losses
and deductions on the individual income tax return, shareholders who
claim losses beyond allowable basis are benefiting improperly. S
corporation stakeholder representatives told us that calculating and
tracking basis was one of the biggest challenges in complying with S
corporation rules.
To gain further perspective on incorrect basis reporting, we analyzed
IRS's annual examinations of individual tax returns that closed for
fiscal years 2006 through 2008. In those examinations, the amount of
the misreported losses that exceeded basis limitations was over $10
million, or about $21,600 per taxpayer. According to IRS examination
officials, lack of basis is one of the largest issues for an S
corporation shareholder's tax return, and they noted that these
misreported amounts understate shareholder noncompliance because IRS
examiners are not fully recording codes in the examination database to
identify basis misreporting.
The S corporation NRP examinations could detect an indication of
noncompliance with basis issues through the Form 1120S but IRS would
need to audit the Form 1040 to verify that noncompliance. As such,
shareholder noncompliance was not fully measured because not all
shareholders from the S corporation NRP were examined. If a shareholder
owned a 20 percent or more interest in an S corporation reporting a net
loss, the examiner was required to consider three loss limitation
rules--basis, at-risk, and passive activity.[Footnote 33] Even though
estimates are not available, IRS officials said that the NRP showed
that some shareholders did not properly track and report their basis,
and as a result, improperly used S corporation losses to offset other
income on their individual tax returns.
Shareholders are responsible for calculating and tracking basis. While
the Schedule K-1 sent to shareholders lists some information that can
be used to calculate basis, S corporations are not required to report
any basis calculations to shareholders. The only information on how to
calculate stock basis is on the Schedule K-1 instructions.
Specifically, a voluntary IRS worksheet in the K-1 instructions can be
used to calculate stock basis. However, some industry representatives
said they do not use the worksheet but instead have come to rely on
computer software, which they said is adequate to calculate stock and
debt basis at the entity level, and in some cases, provide that
calculation to its shareholders.
IRS Addresses S Corporation Tax Noncompliance in Enforcement and
Service Programs:
IRS enforces compliance with S corporation rules through document
matching and examination programs. The Automated Underreporter Program
(AUR) matches individual tax returns with information return documents
and assesses taxes on those with significant enough discrepancies. For
S corporations, AUR matches pass-through income reported on the
Schedule E of a Form 1040 to the Schedule K-1. For tax year 2006, AUR
assessed over $49 million on just almost 5,200 taxpayers with this
mismatch issue, though this number also includes partnerships as well
as S corporations. The issue ranked 14th out of 56 different AUR
categories in terms of dollars assessed.
Examinations are used to check reporting compliance on tax returns, but
due to limited resources, IRS examines only a small portion of S
corporations. In fiscal year 2008, IRS examined over 16,000 S
corporation returns, which equates to less than 0.5 percent of all S
corporations filing tax returns. Of those examined, the items most
commonly examined were gross receipts or sales, purchases, shareholder
compensation, and other deductions. Due to data reliability concerns,
we were not able to analyze IRS's examination results for S
corporations, such as how often IRS found misreporting and the amount
misreported.[Footnote 34]
One way that examiners detect S corporation noncompliance is IRS's yK1
software program, which uses Schedule K-1 information to graphically
depict relationships among taxpaying entities. It displays the
shareholders of S corporations as well as any other businesses that are
linked to the S corporation, including parent companies and
subsidiaries that have common shareholders with the S corporation.
Starting with a business entity or individual shareholder, yK1 can show
its connections in sending or receiving Schedule K-1s. It shows common
use of paid preparers, some family relationships (e.g., husband/wife),
and common addresses, among other linkages. For example, if IRS
discovers noncompliance that is related to a scheme marketed by a
preparer, IRS can use yK1 to identify other entities that used the same
preparer. In addition to K-1 data, IRS pulls data from various IRS
databases, such as those showing data from filed returns or from
information returns filed by third parties. Although there have been no
formal analyses of yK1's effectiveness, IRS officials say that its
examiners report that using yK1 has helped to identify millions of
dollars in unpaid taxes from entities, including S corporations. For S
corporations, yK1 data can help examiners determine if the shareholder
has stock or debt basis, as well as establish trends in officer's
compensation.
IRS aims to educate taxpayers about S corporation rules through its
service activities. IRS does not have a publication specific to S
corporations but publishes detailed instructions to Forms 1120S and
Schedule K-1. IRS also has a toll-free telephone number through which
it routes callers to a specialist who can answer questions about S
corporations. IRS's Web site has a page that provides information on S
corporation filing requirements, with links to other pages on basis,
compensation, and shareholders. Finally, IRS sends a letter to newly
elected S corporations, alerting these entities that S corporations
generally have to pay adequate compensation and that they should
contact IRS or go to [hyperlink, http://www.irs.gov] for more
information. The letter does not communicate basis requirements or
direct taxpayers to specific IRS Web sites related to S corporations.
Options Could Help Further Address S Corporation Noncompliance:
As table 6 shows, we developed options for improving compliance with S
corporation rules based on interviews with S corporation industry
representatives and IRS officials.
Table 6: Options for Improving Compliance with S Corporation Rules:
Challenge: Preparer mistakes;
Options: Investigate ways to improve performance of practitioners
preparing S corporation returns, such as licensing, education, or
penalties.
Challenge: Calculating basis;
Options: Legislative change to require basis calculation at entity
level.
Challenge: Calculating basis;
Options: IRS mailing information on basis calculation to new S
corporations.
Challenge: Calculating basis;
Options: IRS issuing clear, concise guidance for calculating debt
basis.
Source: GAO analysis.
[End of table]
Option to Address Preparer Mistakes:
IRS could improve compliance by investigating options to reduce
preparer errors and preparer complicity with noncompliance. Ways to do
this include licensing, education, and preparer penalties.
The accuracy of S corporation returns might be improved through the
regulation of paid preparers, such as legislation that requires
preparers who work on S corporation returns to be licensed. We reported
in 2008[Footnote 35] that federal individual tax returns filed by
taxpayers in Oregon, which has a rigorous preparer licensing
requirement, were more likely to be accurate compared to those filed by
taxpayers in the rest of the country. Preparers in Oregon have to pass
an open book examination to receive their licenses to practice, and
about 68 percent of the people taking the examination passed. While the
people who did not pass cannot legally prepare tax returns in Oregon,
paid preparers with an equivalent lack of demonstrated ability may well
be working as paid preparers in other states. Further, the IRS
Commissioner announced in June 2009 that he will propose a
comprehensive set of recommendations to help IRS better leverage the
tax return preparer community with the twin goals of increasing
taxpayer compliance and ensuring high ethical standards of tax
preparers.
Variations on this option could be to require a special certification
specific to S corporations, or a certification that covers all business
returns. One tax preparation stakeholder representative said that he
has seen preparers who primarily work on individual income tax returns
prepare an occasional Form 1120S return; such preparers may not be
sufficiently knowledgeable about S corporations, which can lead to
mistakes. Instituting preparer licensing requirements would increase
the likelihood that a preparer is qualified to prepare an S corporation
tax return. One representative said that if he cannot adequately
prepare a return, he will refer a client to another preparer, but he
believes that many preparers would prepare the return anyway because
they want the income. Another representative said that instructions to
Form 1120S should state that S corporation taxation is a complex area
of the law and is different from individual tax law, and should suggest
that the taxpayer seek guidance from a reputable tax consultant in tax
return preparation. As IRS develops preparer standards, ensuring that S
corporation preparers abide by different rules than individual
preparers would acknowledge the vast differences in tax law between
these two groups and potentially improve preparer performance for its
taxpayers.
Penalties levied on preparers who make mistakes on tax returns are an
important tool in improving compliance. Similar to preparers of
individual tax returns, penalties can be asserted for S corporation
preparers when the tax return they prepared understates tax liability.
[Footnote 36] However, one set of stakeholder representatives cautioned
that the penalties for preparer mistakes may not be helping boost
compliance with S corporation rules. Examiners are limited in asserting
penalties on S corporation preparers because the penalties are based on
the tax liabilities, which is not assessed at the entity level but is
passed through to shareholders. Thus, the penalty for substantial
understatement of tax liability generally would not be assessed against
the preparer of an inaccurate Form 1120S return. According to IRS
officials, only when an examiner identifies a preparer mistake through
a shareholder return, such as for basis or passive activity loss, would
an examiner assess the preparer for penalties. IRS agreed to act on our
June 2009 recommendation to evaluate penalty administration and
penalties' effect on voluntary compliance by developing a plan to
collect and analyze penalty-related data.[Footnote 37] IRS does not
have data to show how often penalties are levied on preparers for S
corporations compared to individuals or other business. Because IRS
does not collect these data by entity type, its ability to evaluate the
penalties related to Form 1120S preparers is impeded.
Options to Improve Calculation of Basis:
One option for improving compliance with basis rules is for Congress to
require S corporations to calculate basis and report each shareholder's
basis on Schedule K-1. This could improve compliance to the extent that
record-keeping and expertise in basis calculations are better at the
entity level than the shareholder level. IRS officials said that during
examinations some shareholders are not aware of the basis calculation
requirement. This option would most likely help bring some S
corporations into compliance by requiring that the calculation be
explicitly reported to both shareholders and IRS. In addition, it
likely would be most useful for S corporations with multiple
shareholders since, for instance, the business and the shareholder are
the same in single-shareholder S corporations. Some larger S
corporations already report basis information to their shareholders,
according to a stakeholder representative.
The least burdensome way for S corporations to calculate basis for
their shareholders would be to limit the required calculation to
information already possessed by the S corporations; the shareholder
would be required to know about and track the information missing from
S corporations' calculations. The other way would be to require S
corporations to obtain as much missing information from each
shareholder as possible in order to more fully calculate stock and debt
basis. This would be more burdensome on S corporations but would be
more helpful to shareholders, especially if shareholders are less
likely than S corporations to know what information is needed. Because
some S corporations' tax return programs already compute shareholders'
stock and debt basis, the additional burden is minimized. This
requirement is similar to that which will require brokers to track
basis on investments for their clients.[Footnote 38]
Such missing information at the S corporation level could include a
shareholder's initial cost to buy stock from another shareholder, and
the value of stock on the date of death for inheritances. According to
IRS officials and an S corporation stakeholder representative,
information on stock resale can be readily attained by the entity.
Currently, shareholders must inform an S corporation of the date and
amount of shares transferred to update ownership information and enable
the S corporation to properly allocate income and losses between
shareholders. It may not be a significant extra burden to require
shareholders to also report the cost of the stock to the corporation at
the time of acquisition. IRS officials told us that it is not common
for only shareholders to possess such basis-related information.
However, some industry representatives cautioned that requirements like
these would create work for S corporations, and that information on the
cost of stock sold or inherited should not be provided to S
corporations in order to preserve shareholder privacy.
In addition, partnerships are required to report a similar calculation
on their Schedule K-1s to their partners. Partnerships are to report
capital account[Footnote 39] and liability information that can be used
as an approximate calculation for basis.[Footnote 40] S corporations'
shareholders do not have a capital account, although the Schedule K-1
does require the entities to report items affecting basis. Stakeholder
representatives told us that having similar reporting for S
corporations as with partnerships would make sense and improve
compliance.
A second option to increase compliance with basis rules is for IRS to
send information on basis calculations to newly elected S corporations.
Rules could be distributed by U.S. mail, e-mail, or both. While some
industry representatives told us that they thought most new S
corporation owners would not understand how to track basis and would
not pay attention to IRS information about basis, other representatives
told us that it would at least alert these new S corporation owners
that they have to keep track of something, even if they don't know how
to track it. The owners might then hire an accountant who would keep
track of basis. Information sent to newly elected S corporations could
also provide specific guidance on appropriate record keeping.
Another option to aid taxpayers in computing shareholder basis is for
IRS to publish a clear, one or two-page guidance sheet for calculating
debt basis. We developed this option based on input from some industry
representatives that additional guidance on basis would improve
compliance as well as from IRS officials who indicated the need for
such a worksheet. According to IRS officials, determining valid debt
basis is a major challenge in calculating shareholder basis. The only
IRS information for shareholders on calculating their basis is an IRS
worksheet in the K-1 instructions on calculating stock basis. A similar
worksheet for calculating debt basis might aid taxpayers and preparers
in correctly calculating their full basis but its impact may be
limited. Some industry representatives told us that they do not use
this stock basis worksheet as tax preparers for S corporations
generally use professional tax software to calculate basis at the
entity level, and provide the results to the corporation's
shareholders. Thus, it is difficult to know whether a similar worksheet
on debt basis would increase compliance directly or indirectly.
Further, the complexity of issues involved in calculating debt basis
would not easily lend itself to a simplified worksheet. IRS officials
who tried to develop a concise debt basis worksheet said that too many
variables confounded their effort.
However, guidance is among the least costly ways to improve taxpayer
compliance, so this option could be cost-effective even if only a small
percentage of taxpayers made use of the guidance. IRS officials stated
that such impacts would be enhanced if the law was simplified to make
debt basis part of stock basis; doing so would decrease the
complexities and help taxpayers comply with basis rules, but also would
materially change the essence of the current S corporation law.
Inadequate Wage Compensation to S Corporation Shareholders Creates
Employment Tax Noncompliance, Which Could be Addressed through
Legislative or Administrative Changes:
Unlike other types of business entities, S corporations have a possible
avenue, whether used unintentionally or intentionally, to avoid
employment taxes on payments made to shareholders. S corporation
shareholders can receive both wages and distributions; but only wages
are subject to employment taxes that are to be paid by both the S
corporation and those receiving wages. [Footnote 41] As a result, S
corporations that improperly pay lower shareholder wages while
increasing other payments such as distributions to shareholders, lower
employment tax liabilities.
S corporation shareholders who provide labor as employees of the S
corporation are subject to employment taxes on their reasonable
compensation. Generally, an officer of an S corporation is considered
to be an employee of the corporation for federal employment tax
purposes,[Footnote 42] and thus employment taxes must be paid on an
estimate of "reasonable" or adequate shareholder wage compensation.
[Footnote 43] However, the difficulty and subjectivity in determining
what constitutes an adequate wage enables some S corporations to pay
inadequate wage compensation for the labor provided and compensate
their officers through higher amounts of distributions, payments of
personal expenses, and/or loans.
Compared to S corporations, other entity types operate under different
employment tax rules.[Footnote 44] For example, partnerships and sole
proprietorships are not subject to the same employment tax liabilities
as are S corporations. Specifically, general partners and sole
proprietors are not employees for which employment taxes are to be paid
based on wages. Instead, they are considered to be self-employed and
must pay self-employment tax on all net earnings derived by the entity.
[Footnote 45] Therefore, the partner or sole proprietor is not able to
take an inadequate wage to improperly reduce their employment tax
liabilities.
Some S Corporations Pay Inadequate Shareholder Compensation and Avoid
Employment Taxes:
According to NRP data for tax years 2003 and 2004, about 13 percent of
S corporations paid inadequate wage compensation, resulting in just
over $23.6 billion in net underpaid wage compensation to shareholders.
[Footnote 46] To illustrate the potential impact on employment tax
revenue loss from paying inadequate wages, we applied the maximum
Federal Insurance Contributions Act (FICA) tax rate of 15.3 percent to
the net underpayment amount to compute a simplified calculation of
around $3 billion in employment tax revenue losses over tax years 2003
and 2004. Being just for illustrative purposes, this simplified
calculation could be too high or too low because it did not attempt to
account for all factors that affect employment taxes. For example, all
income above the FICA maximum ($106,800 in 2009) is taxed at a lower
2.9 percent rate, which would lower the tax figure.[Footnote 47] The
net effect could be understated because we excluded the 6.2 percent
federal unemployment tax due on the first $7,000 in wages. Further,
because NRP cannot detect all noncompliance, net effects could be
understated.[Footnote 48]
S corporations with the fewest shareholders made up the largest portion
of shareholder compensation net underpayments. For example, single
shareholder S corporations accounted for most of the net underpayments
and those with one to three shareholders accounted for almost all of
the net underpayment as shown in figure 2.[Footnote 49] The median
misreporting adjustment for underpaid shareholder compensation in all
categories was $20,127.[Footnote 50]
Figure 2: Net Value of Adjustments for Shareholder Compensation in
Billions, by Number of Shareholders, Tax Years 2003 and 2004 Combined:
[Refer to PDF for image: vertical bar graph]
Number of shareholders: 1;
Total adjustments: $14.2 billion.
Number of shareholders: 2 to 3;
Total adjustments: $8.3 billion.
Number of shareholders: 4 or more;
Total adjustments: -$0.2 billion.
Source: GAO analysis of IRS‘s 2003 and 2004 S Corporation NRP data.
[End of figure]
Current Law Does Not Facilitate Consistent Taxpayer Compliance for
Adequate Shareholder Compensation:
The vagueness of federal tax law on determining adequate wage
compensation for shareholders means that the facts and circumstances
have to be analyzed in each case. Doing so increases the burden for S
corporations to determine adequate compensation and creates
opportunities for avoiding employment taxes by paying inadequate
compensation. A 2005 TIGTA report found that determining adequate
compensation was complex and subjective.[Footnote 51]
Neither the Internal Revenue Code nor Treasury Regulations have
specific guidelines for determining reasonable compensation. However,
the determination of reasonable compensation has been extensively
litigated, and courts generally evaluate the facts and circumstances of
the case to decide whether the wages paid were adequate for the service
performed. In examining reasonableness, the courts apply various
judicially developed factors, although no single factor is considered
determinative or more universally important.
According to IRS examination officials, the lack of a clear legal
standard and the need to consider various facts and circumstances has
made it difficult for IRS to develop comprehensive guidance on what
constitutes an adequate wage amount. Instead IRS's only guidance for
taxpayers is a list of nine factors provided on August 2008 that
various courts have generally considered in determining adequate
compensation on the basis of the facts and circumstances of a case:
[Footnote 52]
* training and experience,
* duties and responsibilities,
* time and effort devoted to the business,
* dividend history,
* payments to nonshareholder employees,
* timing and manner of paying bonuses to key people,
* what comparable businesses pay for similar services,
* compensation agreements, and:
* the use of a formula to determine compensation.
In addition to IRS officials, a majority of stakeholder representatives
indicated that taxpayers were uncertain on how to meet requirements for
paying shareholder compensation. Further, three of the nine stakeholder
groups that we spoke with stated that inadequate shareholder
compensation was one of the biggest compliance problems and that
determining adequate shareholder compensation was highly subjective and
depended on a number of different factors. Further, nearly all of the
stakeholder representatives also indicated that having specific IRS
guidance would be helpful for taxpayers and preparers.
IRS Enforcement of Adequate Shareholder Compensation Has Been Limited:
Several IRS examiners told us that arriving at a justifiable conclusion
about what constitutes adequate compensation can be difficult, time
consuming, and result in a relatively low tax adjustment for the work
involved. In determining adequate shareholder compensation, IRS
examiners that we interviewed stated that they look at a variety of
factors. However, due to the difficulties in determining adequate
shareholder compensation, examiners said that they tend to only pursue
the issue in the most egregious cases where shareholders are paid
little to no wages and receive large distributions. A 2002 TIGTA report
found that IRS examiners did not always address officer compensation,
even when little to no compensation was paid.[Footnote 53]
IRS efforts to enforce the rules on paying adequate wage compensation
to S corporation shareholders have been limited, as shown in table 7.
[Footnote 54] In analyzing IRS annual examination data for fiscal years
2006 through 2008, we found that IRS only examined 0.5 percent or less
of the S corporations that filed Form 1120S. IRS examined shareholder
compensation usually in well less than a quarter of these examinations
over these years.
Table 7: Estimated Number of S Corporation Examinations with
Shareholder Compensation Issues, Examinations Closed in Fiscal Years
2006 to 2008:
Number of S corporations filing Form 1120S;
2006: 3,715,249;
2007: 3,909,730;
2008: 4,155,830.
Number of S corporations examined;
2006: 13,970;
2007: 17,657;
2008: 16,634.
Number of S corporations examined for shareholder compensation;
2006: 2,004;
2007: 3,819;
2008: 2,597.
Percentage of all S corporations examined;
2006: 0.4%;
2007: 0.5%;
2008: 0.4%.
Percentage of S corporation examinations that covered adequate
compensation;
2006: 14.3%;
2007: 21.6%;
2008: 15.6%.
Source: GAO analysis of IRS's Databook and EOAD data, fiscal years 2006-
2008.
Note: In general, examination activity is associated with returns filed
in the previous calendar year. The number of S corporations examined
for shareholder compensation does not include all instances when
employment tax returns (Form 941s) are examined.
[End of table]
When examining shareholder compensation in the NRP study, the examiners
generally did not document much analysis of the adequacy of the wages
paid. In our review of randomly selected NRP examination files, we
found evidence of some kind of analysis to determine adequacy in 24 of
114 examinations where we noted that IRS determined that shareholder
compensation needed review.[Footnote 55] These analyses included
benchmarking tools such as monster.com, salary.com, and Bureau of Labor
Statistics (BLS) wage data. In the other 90 examinations, examiners did
not document an analysis, and in some cases merely reconciled an
officer's W-2 form to the return. Examiners made adjustments in 10 of
the 24 cases where documentation showed that an analysis had been made
and in 16 of the other 90 cases. In these 26 examinations with
adjustments due to inadequate shareholder compensation, the adjustment
amount averaged $30,000.
Shareholder Compensation Issues Can be Addressed Through Legislative
Options, but Potential Trade-offs Exist:
Given the concerns of S corporations paying inadequate wage
compensation to shareholders to avoid employment tax obligations and
the burden in determining adequate compensation, legislative options
have been suggested by knowledgeable groups such as the Joint Committee
on Taxation and TIGTA. We analyzed the potential trade-offs in terms of
the pros and cons of each option by meeting with representatives of
nine organizations involved with S corporations including tax lawyers,
tax accountants, and tax preparers as well as IRS officials. The pros
and cons for each option are described qualitatively and are not
intended to be exhaustive or weighted. As a result, we are not ranking
or otherwise making recommendations on the value of each option.
Appendix 1 discusses in more detail how we identified the options as
well as the related trade-offs in terms of potential pros and cons.
The options we reviewed provide a different standard for determining
employment tax liability than the subjective facts and circumstances
criteria used to determine adequate shareholder compensation for
employment tax purposes. To the extent that a new standard is clearer,
S corporations and their shareholders could determine employment tax
liability with less uncertainty and administrative burden, which would
help ensure compliance in paying the correct employment tax amount.
Similarly, clearer criteria would also help IRS examiners ensure
compliance in paying all employment taxes. However, these options also
include trade-offs such as increased taxes for certain S corporations
and shareholders that could offset the advantages of S corporation
status. Table 8 shows the options and their variations.
Table 8: Legislative Options to Address Shareholder Compensation:
Type of option: Basing employment tax liability for shareholders on the
net business income reported by S corporations;
Option variations:
* Make net business income subject to employment taxes;
* Make net business income for service sector businesses subject to
employment taxes;
* Make net business income for majority shareholders subject to
employment taxes.
Type of option: Basing employment tax liability on all types of
payments made to active shareholders;
Option variations:
* Make payments to active shareholders subject to employment tax;
* Make payments to active shareholders up to a dollar tolerance subject
to employment tax.
Type of option: Retain character of income;
Option variations:
* Retain character of income between entities.
Source: GAO analysis of interviews and documents.
[End of table]
The first set of options attempts to reduce the burden on S
corporations for paying the correct amount of employment taxes because
they have to determine adequate wage compensation for each shareholder.
Rather, similar to sole proprietors and partnerships, the basis for
employment tax liability is shifted to the net business income reported
by the S corporation. Table 9 lays out the pros and cons from using the
net business income concept for employment tax purposes.
Table 9: Identified Pros and Cons of Basing Employment Tax Liability
For Shareholders on the Net Business Income Reported by S Corporations:
Pros:
* Simplifies burden by shifting to a new basis for employment taxation;
* Increases uniformity of employment tax treatment by conforming S
corporations and shareholders to the rules for sole proprietorships and
general partners;
* Reduces the chances for shareholders to disguise compensation as
distributions, loans, or personal payments to avoid employment
taxation.
Cons:
* Can be considered to be unfair to impose employment tax on income
that is generated beyond the services provided by a shareholder for the
S corporation;
* Shareholders could still potentially manipulate their returns to
avoid employment taxes such as by incorrectly reporting a net business
loss or reclassifying their business activity;
* S corporations may have difficulty raising capital if investor
returns would be lower from having the employment tax liability.
Source: GAO analysis of interviews and documents.
[End of table]
From our interviews with S corporation stakeholder representatives and
IRS officials, we analyzed three variations in using the net business
income as the basis for employment tax liability. These variations and
additional pros and cons are discussed below.
Make Net Business Income Subject to Employment Taxes. The first
variation in using net business income as the basis for shareholders'
employment tax liabilities in lieu of determining adequate compensation
for each shareholder would make S corporation net income (whether or
not distributed) subject to self-employment tax.[Footnote 56] Doing so
would put the shareholder's employment tax liability on par with the
treatment given general partners in partnerships and to sole
proprietorships. Furthermore, a 2005 JCT report estimated that this
option could raise tax revenues by approximately $57.4 billion over 10
years (fiscal years 2005 to 2014).[Footnote 57] However, including all
net business income instead of just the wages paid to specific
shareholders for the labor provided to S corporations was generally
opposed by stakeholder representatives. Some stakeholder
representatives stated that this shift in the method for determining
employment taxation would be very dramatic or would effectively end the
use of S corporation status. Additionally, some stakeholders also said
that this option would be viewed as unfair for those shareholders whose
income is not based on labor services provided to the S corporation.
Make Net Business Income for Service Sector Businesses Subject to
Employment Taxes. The second variation would have similar pros and cons
but attempt to narrow the negative impact on shareholders who provide
little or no labor to the S corporation. That is, it would only apply
to service sector S corporations,[Footnote 58] making their net
business income (whether or not distributed) subject to self-employment
tax.[Footnote 59] The stakeholder representatives expressed more
comfort with this variation compared to the first because the
employment taxes would be more likely applied to income derived from
services and labor, rather than capital investment, assuming that S
corporations providing services are more likely to have income
generated from the labor of shareholders. In general, stakeholder
representatives still opposed this option. Not all shareholders in
these service corporations would necessarily provide labor services and
other nonshareholder employees could be generating profits for the S
corporation. Furthermore, those S corporations that are generally
nonservice businesses would still have to determine adequate
compensation for each shareholder. Finally, S corporations might escape
this provision by simply misstating business activity as something
other than a "service" business.
Make Net Business Income for Majority Shareholders Subject to
Employment Taxes. The third variation for basing employment taxation on
the net business income of the S corporation would be limited to only
majority shareholders (those holding more than 50 percent of the stock
in an S corporation).[Footnote 60] This would approximate the self-
employment taxation of sole proprietors. As a result, majority S
corporation shareholders and sole proprietors would be put on equal
footing for employment tax purposes. According to 2006 SOI data, 60
percent of all S corporations are owned by just one shareholder with
almost 90 percent owned by one to two shareholders. Further, this
option would help address problems with single shareholder S
corporations, which have a higher incentive to underpay shareholder
wages because their wage determinations are unilateral and can be
structured to avoid employment taxes. For example, sole proprietors pay
employment taxes on their total profits while shareholders who are the
only shareholder of an S corporation are to pay employment taxes on
only the amounts that they unilaterally select as their wages. This
option does not change the current employment tax treatment of
shareholders that hold 50 percent or less of the corporation. As a
result, S corporations would still have to determine adequate
compensation for those shareholders. Further, shareholders could reduce
their level of ownership to less than 50 percent. In addition, it is
possible that some majority shareholders provide little or no labor to
the S corporation.
The second set of options shifts the basis for employment tax liability
from having to determine adequate wage compensation to focusing on all
types of payments made to just active shareholders. Table 10 lists the
basis pros and cons of this set of options.
Table 10: Identified Pros and Cons of Basing Employment Tax Liability
on All Types of Payments Made to Active Shareholders:
Pros:
* Reduces burden of determining adequate compensation;
* Increases uniformity of employment tax treatment by conforming S
corporations and active shareholders to rules for sole proprietorships
and general partners;
* Reduces the chances for shareholders to disguise compensation as
distributions, loans, or personal payments to avoid employment
taxation;
* Only taxes money taken out of the corporation, which increases the
likelihood for a return on capital;
Cons:
* Imposes employment taxes on money taken out of S corporation even if
the shareholder has enough basis for a tax free distribution or pays
back a loan;
* Shareholders may be mischaracterized as "non-active," or not involved
in the operation of the S corporation to avoid taxation;
* S corporations may funnel money through another pass-through entity
to disguise active participation;
* May be unfair to impose employment taxes on income generated beyond
the services of a shareholder.
Source: GAO analysis of interviews and documents.
[End of table]
Our work with the S corporation stakeholder representatives and IRS
officials analyzed two variations for this set of options. The related
pros and cons are discussed below for these two variations. We then
discuss an additional legislative option that attempts to deal with one
tax loophole related to the "character of income."
Make Payments to Active Shareholders Subject to Employment Tax. The
first variation would focus on shareholders who actively participate in
the operation of an S corporation and who would owe employment taxes
based on all payments that they received from the S corporation
including wages as well as personal payments, distributions, or loans.
This option provides broad coverage in reducing the burden of
determining adequate compensation and addresses the issue that the
business should get some return on capital without being taxed on the
investment income the shareholder leaves in the business. However,
stakeholder representatives had some concerns with such coverage. For
example, they said that loans made to shareholders who later pay off
the loan should not be treated as income on which employment taxes are
paid. As with the earlier set of options, they expressed concerns about
imposing employment taxes on income generated from capital invested
rather than labor provided. Furthermore, some active S corporation
shareholders might still avoid taxation by treating themselves as
"inactive".
Make Payments to Active Shareholders Up to a Dollar Tolerance Subject
to Employment Tax. The second variation would have similar pros and
cons but would attempt to limit some negative effects by inserting a
dollar tolerance for all payments made to active shareholders. That is,
for any shareholder who actively participates in the operation of an S
corporation, all payments up to either the FICA maximum ($106,800 in
2009) or up to some other dollar amount such as double the FICA maximum
($213,600 in 2009) are considered compensation for employment tax
purposes. S corporations and shareholders pay lower taxes by not paying
employment taxes on all compensation. By limiting the amount of
payments from the S corporation subject to employment taxation, active
shareholders who have invested capital could receive a distribution
free of employment taxation. In addition, this method would create a
safe harbor for taxpayers wishing to ensure their compliance with
shareholder compensation rules but who are uncertain of the correct
income figure to report. On the other hand, this option would greatly
limit flexibility in certain situations. For example, the dollar
tolerance does not account for differences in payments made to active
shareholders that are prompted by differences in the type of industry
and geographic location, or other factors.
Retain Character of Income Between Entities. The last option we
analyzed does not change the current-law basis for the employment tax
obligations of shareholders. Rather, it attempts to eliminate one
potential method that can be used to avoid employment taxation by using
an S corporation to shelter business income from partnerships.
Specifically, a partner in a partnership would attempt to circumvent
the self-employment rules of partnerships by inserting an S corporation
between the partnership and the individual. Under this option, income
that flows from a partnership to an S corporation will retain its self-
employment tax character until it is passed to an individual. By
retaining the character of the income for employment tax purposes until
it reaches the individual, fewer opportunities for "gaming" the system
exist. However, this option only addresses one specific "loophole" and
can add some complexity to track the income through different entities.
Administrative Options May Help to Decrease Inadequate Compensation
Issues for S Corporations:
In addition to legislative options, we identified two administrative
options that may help address issues involving inadequate shareholder
compensation issues while avoiding some of the cons identified above.
Currently, taxpayer compliance and IRS oversight are hindered partly
because of the absence of a standardized way to determine reasonable
compensation on a consistent basis. Additionally, the lack of taxpayer
education on shareholder compensation rules may also increase
noncompliance according to some stakeholder representatives. To address
these challenges, we identified these two administrative options as
well as their related pros and cons which are discussed below.
Improve guidance to IRS examiners so that they might better target and
determine adequate shareholder compensation. An example of the improved
guidance would be to improve examiner use of tools for making adequate
compensation determinations. During our review of randomly selected NRP
IRS examination case files, we found that in 23 cases, examiners
indicated the use of some form of analysis including 15 cases where
they used salary data from the BLS or other salary tools as a benchmark
for making the adequateness determination. In those cases where we saw
evidence of analysis of shareholder compensation, examiners made
adjustments 10 out of 23 times. When examiners used BLS statistics,
they adjusted shareholder compensation 6 of 9 times. Thus, it appears
that using such a tool could improve the effectiveness of IRS
examinations of shareholder compensation. While the Internal Revenue
Manual (IRM), IRS's official guidance resource, requires examiners to
document their case review, it does not require them to conduct an
analysis of shareholder compensation using tools such as BLS
statistics. Additionally, the IRM does not require examiners to
indicate why an analysis was not used in cases where it is excluded. An
analysis, however, would not reduce the subjectivity and burden for
those S corporations attempting to comply with federal rules and would
not completely address the difficulty examiners face. For example, IRS
officials noted that a shareholder may perform duties for the S
corporation that do not align well with occupation categories available
in salary benchmarking tools or may live in a location without
comparable wage data.
Better educate taxpayers and provide guidance on meeting shareholder
compensation tax obligations. TIGTA has recommended sending out
prefiling information to taxpayers newly electing S corporation status.
Some shareholder representatives told us that some taxpayers may not be
aware of the need to pay officer compensation. For example some
shareholder representatives noted that taxpayers or tax preparers were
not certain about how to meet shareholder compensation requirements and
could benefit from additional guidance through means such as additional
outreach including providing information to new S corporations on
shareholder compensation and improving the guidance on IRS's Web site.
Even though IRS has noted that developing comprehensive guidance for S
corporations can be difficult, such outreach to these unaware taxpayers
could help them better determine adequate compensation for its
shareholders, including those who provide capital to the S corporation
but little or no labor. IRS already provides some training materials to
its examiners on determining adequate compensation that goes beyond the
factors developed through case law; however, these materials are not
publicly available. For example, these materials encourage the use of
wage benchmarking tools from third parties to help determine adequate
compensation. Providing specific guidance such as this could
potentially improve compliance by clarifying this issue for both
taxpayers and tax preparers. Again, this better education and guidance
would not resolve the subjectivity and burden associated with the
"facts and circumstances" test.
Conclusions:
The high percentage of noncompliant S corporations leads to substantial
lost tax revenue for the federal government. Whether mistakes are
intentional or unintentional, misreporting is unfair to compliant
taxpayers and undermines the equity of the tax system. The high rate of
misreporting associated with S corporation returns done by paid
preparers raises concerns about their competency to deal with the tax
complexities arising from S corporation status. New S corporation
owners and their preparers may not have the appropriate skills to
ensure compliance with tax rules, which can require diligent record
keeping and complex basis calculations. Further, the lack of guidance
on determining shareholder compensation is challenging for both
taxpayers and IRS examiners. Without clear guidance or legal
requirements, S corporations tend to underpay shareholder wages,
resulting in underpaid employment taxes for funding programs like
Medicare and Social Security. Nor are IRS examiners fully documenting
or using tools that may assist them to analyze whether adequate
compensation had been paid. Several options could help address these
challenges, either through legislative or administrative change,
although each option has its trade-offs. Any of these options should be
paired with continued attention to taxpayer service and education.
Matter for Congressional Consideration:
To improve compliance with shareholder basis rules, Congress should
require S corporations to calculate and report shareholder's stock and
debt basis as completely as possible. S corporations would report the
calculation on the Schedule K-1 and send it to shareholders as well as
IRS. If Congress judges that stock purchase price information that is
currently only available to shareholders should not be transmitted to
the S corporation due to privacy concerns, an alternative is to require
that S corporations report less complete basis calculations using
information already available to the S corporation.
Recommendations:
To help address the compliance challenges with S corporation rules, we
recommend that the Commissioner of Internal Revenue take the following
four actions:
* Identify and evaluate options for improving the performance of paid
preparers who prepare S corporation returns, such as licensing
preparers and ensuring that appropriate penalties are available and
used.
* Send additional guidance on S corporation rules and record-keeping
requirements to new S corporations to distribute to their shareholders,
including providing guidance on calculating basis and directing them to
the specific IRS Web site related to S corporation tax rules.
* Require examiners to document their analysis such as using comparable
salary data when determining adequate shareholder compensation or
document why no analysis was needed.
* Provide more specific guidance to shareholders and tax preparers,
such as that provided to IRS examiners, on determining adequate
shareholder compensation through means such as IRS's Web site.
Agency Comments:
IRS's Deputy Commissioner for Services and Enforcement provided written
comments on a draft of this report in a December 4, 2009, letter, which
is reprinted in appendix IV. IRS staff also provided technical
comments, which we incorporated into the report as appropriate. The
written comments acknowledged that S corporations represent one of the
fastest growing types of businesses, that their tax misreporting can
produce income tax and employment tax revenue losses, and that tax
administration and compliance efforts involving S corporations can be
challenging.
IRS agreed in principle with our four recommendations. Regarding the
performance of paid tax preparers working on S corporation returns, IRS
agreed with the need to identify and evaluate options to improve the
preparers' performance and noted that by year end a team convened by
the IRS Commissioner would make recommendations to strengthen oversight
of tax return preparers overall. As for our recommendation on sending
additional guidance to new S corporations, IRS agreed to evaluate the
need for additional information to be provided on calculating stock and
debt basis. Our work with S corporation stakeholders and our review of
IRS examinations of the basis issue indicated that more information
about calculating basis is needed. IRS also agreed to modify its
correspondence to new S corporations to direct them to IRS's Web site.
In addition, IRS agreed to ensure that examiners meet workpaper
documentation requirements involving their analysis of comparable
salary data when determining adequate shareholder compensation. IRS was
silent on the second part of our recommendation under which IRS also
would ensure that examiners document their rationale when they
determined no analysis was needed. Our review of examiners' workpapers
indicated a need for documenting why no analysis was done. We found
evidence of an analysis for just 24 of the 114 examinations involving
shareholder compensation, leaving open the questions of whether
examiners did an analysis for the other 90 examinations and if they
did, why they had not documented the analysis. Finally, IRS agreed to
provide on its Web site (IRS.gov) more specific guidance to all S
corporation shareholders and tax preparers on such items as
recordkeeping requirements and determining adequate shareholder
compensation.
As agreed with your offices, unless you publicly announce its contents
earlier, we plan no further distribution of this report until 30 days
after its date. At that time, we will send copies of this report to the
Chairman and Ranking Member, House Committee on Ways and Means; the
Secretary of the Treasury, the Commissioner of Internal Revenue, and
other interested parties. This report is available at no charge on
GAO's Web site at [hyperlink, http://www.gao.gov].
If you or your staffs have any questions about this report, please
contact me at (202) 512-9110 or brostekm@gao.gov. Contact points for
our Offices of Congressional Relations and Public Affairs may be found
on the last page of this report. Key contributors to this report are
listed in appendix V.
Signed by:
Michael Brostek:
Director, Tax Issues Strategic Issues Team:
[End of section]
Appendix I: Scope and Methodology:
Our objectives were to: (1) describe reasons a business might choose to
become an S corporation; (2) analyze the types of S corporation
noncompliance, what the Internal Revenue Service (IRS) has done to
address the noncompliance overall, and options for improvement; and (3)
further analyze the extent of noncompliance involving a long-standing
concern over inadequate shareholder compensation, and identify options
for improving compliance.
To provide background information on the size and growth of S
corporations, we used IRS Statistics of Income (SOI) corporate,
partnership, and individual data for tax years 2000 to 2006 to compare
characteristics of S corporations to other business types. We compared
our results with the published SOI files and determined our data were
reliable for the purposes of our review.
To describe reasons for a business to choose S corporation status, we
reviewed relevant literature from sources such as the Joint Committee
on Taxation (JCT), Treasury Inspector General for Tax Administration
(TIGTA), and the Congressional Research Service (CRS). We interviewed
IRS officials from the Large/Mid-Size Business Division (LMSB), the
Small Business/Self-Employed Division (SBSE), Accounts Management, and
Field Assistance. We also interviewed representatives of industry
organizations that have experience with S corporations, specifically: S
Corporation Association (SCA), National Society of Accountants (NSA),
National Association of Enrolled Agents (NAEA), Small Business Council
of America (SBCA), American Institute of Certified Public Accountants
(AICPA), American Bar Association (ABA), National Association for the
Self Employed (NASE), National Federation of Independent Business
(NFIB), and National Small Business Association (NSBA). Using the
information gathered from these sources, we determined tax and nontax
considerations businesses might use to choose a business entity
election and used these considerations to compare the business entity
types. To analyze the ability of S corporations to pass through losses
to their shareholders, we used the Corporate Master File for tax years
2001 to 2006 to extract data on the number and attributes of S
corporations reporting losses. We restricted our analysis to S
corporations that reported losses in 2003 and filed tax returns in each
year 2001 to 2006. The last line on the Form 1120S Schedule K, titled
Income/Loss Reconciliation in 2006, is the amount that is carried over
onto shareholders' Form 1040s as losses. However, Corporate Master File
data for that line only go back to 2004. To analyze losses from 2001 to
2006, we used the 1120S Ordinary Income and Loss line to measure
whether an S corporation took a loss. We also used the 2001 Individual
National Research Program (NRP), a study of individual taxpayer returns
conducted by IRS, to provide general information on how shareholders
use S corporation income to offset other income. Based on our
assessment, we determined that the Corporate Master File and Individual
NRP database were sufficiently reliable for the purposes of our review.
To analyze the types of S corporation noncompliance, we used data from
the 2003 and 2004 S Corporation NRP. The NRP sample is divided across
12 strata by the type of S corporation tax return filed and asset
classes. IRS accepted as filed some of the NRP returns, accepted others
with minor adjustments, and examined the remainder of returns either
through correspondence or face-to-face meetings with taxpayers. If IRS
examiners determined that taxpayers misreported any aspect of the
selected tax returns, they adjusted the taxpayers' income accordingly
and assessed additional taxes. Misclassification adjustments, where a
taxpayer reports the correct amount but on the wrong line, are included
in our analysis, as are cases where the examiner zeroed out the entire
return. All estimates from the NRP S corporation underreporting study
reflect the total over 2 tax years. From the S corporation NRP, 25
percent of the sample came from tax year 2003 and 75 percent from tax
year 2004, but both tax years 2003 and 2004 have equal input into our
estimates.
We also reviewed a random, nongeneralizable sample of 166 noncompliant
cases from the S Corporation NRP to further illustrate the detailed
reasons for noncompliance. These 166 cases were all returns with at
least one adjustment. We requested 186 cases in May 2009, and received
175. We omitted 9 cases from our sample: 5 did not contain enough
information to determine reasons for adjustments, and 4 were out of
scope. We recorded information from the case files using a data
collection instrument (DCI) that we developed. To ensure that our data
collection efforts conformed to GAO's data quality standards, each DCI
entry that a GAO analyst completed was reviewed by another GAO analyst.
The reviewers compared the data recorded within the DCI entry to the
data in the corresponding case file to determine whether they agreed on
how the data were recorded. When the analysts' views on how the data
were recorded differed, they met to reconcile any differences.
For this assessment, we interviewed IRS officials about the data,
collected and reviewed documentation about the data and the system used
to capture the data, and compared the information we collected through
our case file review to corresponding information in the NRP database
to identify inconsistencies. Based on our assessment, we determined
that the 2003 and 2004 S Corporation NRP data were sufficiently
reliable for the purposes of our review.
To determine what IRS has done to address the noncompliance, we
interviewed IRS officials, and reviewed data from the Automated
Underreporter program to determine the extent of IRS's enforcement
efforts. We also used the Examination Operational Automated Database
(EOAD) for tax years 2006 to 2008. Due to data reliability issues, we
could only report data on how often a tax return was examined.
Specifically, there were multiple entries in EOAD for one misreporting
item where we could not determine whether the examiner made a
correction upward, downward, or no correction to the line item. IRS
officials could not tell us why or how to resolve these multiple
entries. Beyond these limitations, we determined for the purposes of
this review that the data we reported were reliable.
To determine some options for improvement, we interviewed IRS officials
and conducted two rounds of interviews with stakeholder representatives
from the S corporation industry. In the first round we compiled a list
of issues relating to S corporation noncompliance and potential options
for addressing noncompliance. In the second round, we provided the list
compiled in the first round to the stakeholders and asked whether or
not the stakeholders agreed that an issue was a problem, whether or not
they agreed with the proposed solutions, and discussed the tradeoffs
associated with each option. These issues, options, and trade-offs are
not an exhaustive list but represent our analysis and the general views
of a knowledgeable community related to S corporations. We also
collected information from IRS's Web site and service programs.
To examine the extent to which shareholder compensation contributes to
S corporation noncompliance, we also used data from the S Corporation
NRP and the EOAD. We also reviewed the types of shareholder
compensation analysis conducted by IRS examiners in the sample of 166
cases we reviewed. To determine options for improving compliance on
shareholder compensation, we spoke with experts and knowledgeable
individuals on S corporation shareholder compensation issues. These
experts included IRS technical advisors and other relevant staff as
well as knowledgeable representatives for various national
organizations that represent S corporations, tax return preparers or
tax lawyers. From this work, we consolidated the list of options. Based
on prior GAO reports on similar issues, a literature review of other
reports, and discussions with the parties mentioned above, we developed
a list of criteria for evaluating the options: equity, taxpayer impact
and burden, simplicity, transparency, feasibility, and return (whether
the option unduly limits potential financial returns for S
corporations). We then spoke with stakeholders a second time to develop
a list of pros and cons for each option based on these criteria. All
percentage estimates in this report have 95 percent confidence
intervals that are within +/-8 percentage points of the estimate
itself, unless otherwise specified. All other estimates in this have 95
percent confidence intervals that are within +/-10 percent value of the
estimate itself, unless otherwise specified. We conducted this
performance audit from May 2007 to October 2009 in accordance with
generally accepted government auditing standards. Those standards
require that we plan and perform the audit to obtain sufficient,
appropriate evidence to provide a reasonable basis for our findings and
conclusions based on our audit objectives. We believe that the evidence
obtained provides a reasonable basis for our findings and conclusions
based on our audit objectives.
[End of section]
Appendix II: Trends in the Growth of S Corporations:
[End of section]
Number of S Corporations:
S corporations are the second most common type of business, as shown in
figure 3. In tax year 2006, 12.6 percent of all businesses were S
corporations. The rate of growth of S corporations from tax year 2000
to tax year 2006 was 35 percent, while the rate of growth across all
business types was 23 percent.
Figure 3: Number of Businesses by Business Type, Tax Years 2000 to
2006:
[Refer to PDF for image: line graph]
Tax year: 2000;
S corporation: 2.9 million;
C corporation: 2.2 million;
Partnership: 2.1 million;
Nonfarm sole proprietorship: 17.9 million.
Tax year: 2001;
S corporation: 3.0 million;
C corporation: 2.1 million;
Partnership: 2.1 million;
Nonfarm sole proprietorship: 18.3 million.
Tax year: 2002;
S corporation: 3.2 million;
C corporation: 2.1 million;
Partnership: 2.2 million;
Nonfarm sole proprietorship: 18.9 million.
Tax year: 2003;
S corporation: 3.3 million;
C corporation: 2.1 million;
Partnership: 2.4 million;
Nonfarm sole proprietorship: 19.7 million.
Tax year: 2004;
S corporation: 3.5 million;
C corporation: 2.0 million;
Partnership: 2.5 million;
Nonfarm sole proprietorship: 20.6 million.
Tax year: 2005;
S corporation: 3.7 million;
C corporation: 2.0 million;
Partnership: 2.8 million;
Nonfarm sole proprietorship: 21.5 million.
Tax year: 2006;
S corporation: 3.9 million;
C corporation: 2.0 million;
Partnership: 2.9 million;
Nonfarm sole proprietorship: 22.1 million.
Source: GAO analysis of IRS‘s Statistics of Income (SOI) data.
[End of figure]
Number of Shareholders:
Most S corporations are held by three or fewer shareholders. In tax
year 2006, 60 percent of S corporations were single-shareholder
businesses, 89 percent had two or fewer shareholders, and 94 percent
had three or fewer shareholders.
From tax years 2000 to 2006, growth in the number of S corporations
with three or fewer shareholders exceeded growth in the number of S
corporations with four or more shareholders. Additionally, as shown in
figure 4, S corporations held by three or fewer shareholders accounted
for the majority of S corporation assets, net income, gross business
receipts, and deductions in 2006, and S corporations held by a single
shareholder accounted for over 30 percent of S corporation assets, net
income, gross business receipts, and deductions.
Figure 4: Share of Total Net Income, Business Receipts, Deductions, and
Assets by Number of Shareholders, Tax Year 2006:
[Refer to PDF for image: stacked vertical bar graph]
Assets:
Single shareholder: 31%;
2 shareholders: 19%;
3 shareholders: 9%;
4 or more shareholders: 41%.
Net income:
Single shareholder: 39%;
2 shareholders: 22%;
3 shareholders: 9%;
4 or more shareholders: 29%.
Gross business receipts:
Single shareholder: 36%;
2 shareholders: 26%;
3 shareholders: 11%;
4 or more shareholders: 28%.
Deductions:
Single shareholder: 33%;
2 shareholders: 25%;
3 shareholders: 11%;
4 or more shareholders: 28%.
Source: GAO analysis of IRS‘s SOI data.
Note: Columns may not sum to 100 because of rounding.
[End of figure]
Conversions:
As shown in figure 5, between 78,000 to 97,000 C corporations converted
to S corporations each year from 2000 to 2006,[Footnote 61]
representing 23 to 31 percent of new S corporations each year.
Figure 5: Newly Elected S Corporations, Tax Years 2000 to 2006:
[Refer to PDF for image: stacked vertical bar graph]
Tax year: 2000;
New businesses: 212,000;
Conversions from C corporations: 92,000.
Tax year: 2001
New businesses: 206,000;
Conversions from C corporations: 93,000.
Tax year: 2002
New businesses: 243,000;
Conversions from C corporations: 87,000.
Tax year: 2003
New businesses: 253,000;
Conversions from C corporations: 88,000.
Tax year: 2004
New businesses: 263,000;
Conversions from C corporations: 78,000.
Tax year: 2005
New businesses: 263,000;
Conversions from C corporations: 91,000.
Tax year: 2006
New businesses: 250,000;
Conversions from C corporations: 97,000.
Source: GAO analysis of IRS‘s SOI data.
Note: Estimates for new businesses are within +/-9 percent of the
reported values. Estimates for conversions from C corporations are
within +/-14 percent of the reported values.
[End of figure]
[End of section]
Appendix III: Analysis of S Corporation Losses:
Since nearly 70 percent of S corporations are noncompliant with tax
rules and the vast majority of these underreported income, many likely
took a loss when they should have reported a profit or increased the
size of the loss. Because S corporation shareholders can not only
offset S corporation income, but other income too (within limits), S
corporation owners' noncompliance can "shelter" other income. S
corporations that take losses tend to take them in multiple years, and
S corporation shareholders that took losses on their tax returns in
2001 offset an average of 16.6 percent of their income with those
losses. Median losses for S corporations in tax years 2001 to 2006
ranged from $277,000 to $352,000.[Footnote 62]
Loss-Taking at the S Corporation Level:
We examined loss and gain patterns in 2001 to 2006 for S corporations
that took ordinary losses in 2003. Twenty-eight percent of the 45,450 S
corporations in the 2003 SOI sample (12,651 S corporations) took
losses. Of these, GAO analyzed the 9,152 that filed returns in all 6
years 2001 to 2006, to facilitate a multiyear analysis.
Of these 9,152 S corporations, 24 percent took losses in all 6 of the
years, and 79 percent took losses in at least 3 of the 6 years, as
shown in table 11. Additionally, 51 percent took losses in 4 or more
consecutive years, as shown in table 12.
Table 11: S Corporations Taking Ordinary Losses in Multiple Years, Tax
Years 2001 to 2006:
Based on 9,152 S corporations that took losses in tax year 2003[A]:
Percent of S corporations claiming losses in 2003 that claimed losses
in all 5 other years 2001-2006: 24.02%.
Percent of S corporations claiming losses in 2003 that claimed losses
in 4 other years 2001-2006: 18.36%.
Percent of S corporations claiming losses in 2003 that claimed losses
in 3 other years 2001-2006: 19.07%.
Percent of S corporations claiming losses in 2003 that claimed losses
in 2 other years 2001-2006: 17.65%.
Percent of S corporations claiming losses in 2003 that claimed losses
in 1 other year 2001-2006: 13.02%.
Percent of S corporations claiming losses in 2003 that claimed losses
in no other years 2001-2006: 7.85%.
Source: GAO analysis of IRS Corporate Master File data.
[A] 12,651 S corporations took losses in tax year 2003; GAO performed
this multiyear loss analysis on the 9,152 of those that filed tax
returns in all 6 years 2001-2006.
[End of table]
Table 12: S Corporations Taking Ordinary Losses in Consecutive Years,
Tax Years 2001 to 2006:
Based on 9,152 S corporations that took losses in tax year 2003:
Percent of S corporations claiming losses in 2003 that claimed losses
in all 6 years 2001-2006: 24.02%.
Percent of S corporations claiming losses in 2003 that claimed losses
in 5 consecutive years 2001-2006: 9.81%.
Percent of S corporations claiming losses in 2003 that claimed losses
in 4 consecutive years 2001-2006: 16.81%.
Percent of S corporations claiming losses in 2003 that claimed losses
in 3 consecutive years 2001-2006: 17.66%.
Percent of S corporations claiming losses in 2003 that claimed losses
in 2 consecutive years 2001-2006: 17.13v.
Percent of S corporations claiming losses in 2003 that did not have
consecutive years of losses in 2001-2006: 14.53%.
Source: GAO analysis of IRS Corporate Master File data.
[End of table]
S corporation losses were substantial, as shown in table 13, ranging
from a median loss of about $277,000 in 2003 to a median loss of about
$352,000 in 2004.[Footnote 63] Total losses claimed for all S
corporations taking losses in 2003 were $11.4 billion.
S corporations that took losses in 2003 were more likely to take losses
in 2002 and 2004 than in 2001, 2005, and 2006, as shown in table 13,
which is not surprising since businesses tend to have periods of
greater and lesser success that span multiple consecutive years.
Table 13: S Corporation Ordinary Losses, Tax Years 2001-2006, for S
Corporations that Took Losses in 2003:
Number of S corporations claiming losses;
2001: 5,200;
2002: 5,966;
2003: 9,071[A];
2004: 6,068;
2005: 5,134;
2006: 5,076.
Percentage of S corporations claiming losses;
2001: 57;
2002: 65;
2003: 99[A];
2004: 66;
2005: 56;
2006: 55.
Median size of S corporation losses (in 2009 dollars);
2001: $278,380;
2002: $307,938;
2003: $277,178;
2004: $351,782;
2005: $307,287;
2006: $310,124.
Source: GAO analysis of IRS's Corporate Master File data.
Note: Dollar amounts are adjusted to 2009 dollars.
[A] 9,152 S corporations that took losses in 2003 were identified using
IRS SOI data, and information on these businesses for tax years 2001 to
2006 was obtained from IRS Corporate Master File data. Due to minor
discrepancies between these data sources, only 99% (9,071) are
identified in the Corporate Master File as taking losses in 2003.
[End of table]
S corporation losses varied by number of shareholders, as shown in
figure 6. In general, the trend is that S corporations with fewer
shareholders are more likely to take losses, with the exception that
very large S corporations with 51 or more shareholders are most likely
to take losses.
Figure 6: S Corporation Loss Taking By Number of Shareholders, Tax Year
2006:
[Refer to PDF for image: vertical bar graph]
Number of shareholders: 1;
Percentage taking losses: 61%.
Number of shareholders: 2;
Percentage taking losses: 54%.
Number of shareholders: 3;
Percentage taking losses: 51%.
Number of shareholders: 4-5;
Percentage taking losses: 50%.
Number of shareholders: 6-10;
Percentage taking losses: 51%.
Number of shareholders: 11-50;
Percentage taking losses: 49%.
Number of shareholders: 51+;
Percentage taking losses: 62%.
Source: GAO analysis of IRS‘s Corporate Master File data.
[End of figure]
Loss-Taking at the Shareholder Level:
An analysis of shareholder Forms 1040 shows how taxpayers can benefit
from taking S corporation losses. Based on an analysis of NRP data, 42
percent of taxpayers who were S corporation shareholders took a loss in
2001, with a median loss amount of $6,930.[Footnote 64] As shown in
table 14, total claims for all taxpayers were $40.2 billion.[Footnote
65] Most losses were nonpassive: 35.7 percent of taxpayers with S
corporations claimed nonpassive losses, with only 5.1 percent claiming
passive losses. Nonpassive losses were also larger, with a median claim
of $7,412, compared to a median of $2,978 for passive losses.[Footnote
66]
Table 14: Total and Median Ordinary Losses Claimed by S Corporation
Shareholders, Tax Year 2001:
Taxpayers claiming: Passive loss only;
Number of taxpayers: 147,011;
Percentage of taxpayers: 5.10;
Total losses claimed (billions): $3.14;
Median losses claimed: $2,978[A].
Taxpayers claiming: Nonpassive loss only;
Number of taxpayers: 1,028,434;
Percentage of taxpayers: 35.65;
Total losses claimed (billions): $32.21;
Median losses claimed: $7,412[A].
Taxpayers claiming: Both passive and nonpassive loss;
Number of taxpayers: 45,217;
Percentage of taxpayers: 1.57;
Total losses claimed (billions): $4.84;
Median losses claimed: [A].
Taxpayers claiming: No loss;
Number of taxpayers: 1,663,852;
Percentage of taxpayers: 57.68;
Total losses claimed (billions): [Empty];
Median losses claimed: [Empty].
Taxpayers claiming: Total;
Number of taxpayers: 2,884,514;
Percentage of taxpayers: 100.00;
Total losses claimed (billions): $40.19;
Median losses claimed: [Empty].
Source: GAO analysis of IRS's 2001 NRP data.
Notes: Percentage estimates are within +/-3 percentage points.
Estimates of numbers of taxpayers are within +/-37 percent of the
reported value. Total dollar estimates are within +/-49 percent of the
reported value. Median dollar estimates are within +/-58 percent of the
reported value.
[A] The overall median loss for taxpayers claiming losses (including
taxpayers with passive losses only, nonpassive losses only, and both
passive and nonpassive losses) was $6,930.
[End of table]
Of shareholders claiming losses, 11.3 percent claimed losses for more
than one S corporation. These shareholders claimed much greater amounts
in losses, with a median of $27,929 claimed in losses, compared to
$5,797 for shareholders claiming losses for only one S corporation.
[Footnote 67] Nonetheless, of the total dollars of losses claimed
($40.2 billion), most ($25.5 billion) were claimed by shareholders
reporting losses for only one S corporation.[Footnote 68]
Some S corporation shareholders may use losses from one S corporation
to offset gains from another. Of shareholders claiming losses, 29
percent claimed gains from a different S corporation.
On average, shareholders taking losses from S corporations in 2001
offset 16.6 percent of their income with S corporation losses. See
table 15 for amounts of offset broken down by income brackets.
Table 15: Percentage of Non-S-Corporation Income Offset by S
Corporation Losses, Tax Year 2001:
Non-S-corporation income bracket: Less than $50,000;
Percentage of other income offset by S corporation loss: Estimate
unreliable.
Non-S-corporation income bracket: $50,000 - $100,000;
Percentage of other income offset by S corporation loss: 17.6.
Non-S-corporation income bracket: $100,000 - $250,000;
Percentage of other income offset by S corporation loss: 20.4.
Non-S-corporation income bracket: Over $250,000;
Percentage of other income offset by S corporation loss: 10.9.
Non-S-corporation income bracket: Total;
Percentage of other income offset by S corporation loss: 16.6.
Source: GAO analysis of IRS's 2001 NRP data.
[End of table]
[End of section]
Appendix IV: Comments from the Internal Revenue Service:
DEPARTMENT OF THE TREASURY:
INTERNAL REVENUE SERVICE:
DEPUTY COMMISSIONER:
WASHINGTON, D.C. 20224:
December 4, 2009:
Mr. Michael Brostek:
Director, Tax Issues:
United States Government Accountability Office:
Washington, DC 20548:
Dear Mr. Brostek:
Thank you for the opportunity to review the Government Accountability
Office's (GAO) draft entitled, "Tax Gap: Actions Needed to Address
Noncompliance with S Corporation Tax Rules (GA0-10-195)."
We recognize S corporations represent one of the fastest growing
business types and accounted for nearly four million businesses in
2006. We agree that S corporation misreported items and miscalculations
of shareholder basis can result in revenue losses in employment taxes
and individual income taxes.
We appreciate your acknowledgement of the challenges of tax
administration related to S corporations and our efforts to address
compliance for these entities as well as for their shareholders. We
agree to provide additional guidance on the IRS website to clarify the
S corporation tax rules, recordkeeping requirements, determination of
adequate shareholder compensation and the shareholder's responsibility
for calculating stock and debt basis. Additionally, examiners are
currently required to document the consideration of the adequate
shareholder compensation issue in their audit workpapers and we will
reemphasize this requirement.
Your report identifies various options to help address noncompliance
with S corporation tax rules and improve the performance of paid tax
preparers. We are in the process of issuing recommendations that will
heighten our overall oversight of paid tax preparers to improve
compliance.
The enclosed response addresses each recommendation separately.
If you have questions or concerns, please contact Christopher Wagner,
Commissioner, Small Business/Self-Employed Division at (202) 622-0600.
Sincerely,
Signed by:
Steven T. Miller:
Enclosure:
[End of letter]
Enclosure:
Recommendation 1:
Identify and evaluate options for improving the performance of paid
preparers who prepare S corporation returns, such as licensing
preparers and ensuring that appropriate penalties are available and
used.
Comment:
We agree in principle that we should identify and evaluate options for
improving the performance of paid preparers including those who prepare
S corporation returns, such as licensing preparers and ensuring that
appropriate penalties are used. Commissioner Shulman's Tax Preparer
Review team will be making recommendations by the end of the year which
will significantly strengthen the oversight of tax return preparers.
Recommendation 2:
Send additional guidance on S corporation rules and record keeping
requirements to new S corporations to distribute to their shareholders,
including providing guidance on calculating basis and directing them to
the specific IRS website related to S corporation tax rules.
Comment:
We agree to review current correspondence sent out upon acceptance of
an S corporation election and will evaluate whether additional
information is needed regarding the shareholder's responsibility for
calculating stock and debt basis. We agree to modify current
correspondence sent out upon acceptance of an S election to direct new
S Corporations to the IRS.gov website.
Recommendation 3:
Require examiners to document their analysis such as using comparable
salary data when determining adequate shareholder compensation or
document why no analysis was needed.
Comment:
We currently require examiners to document in their workpapers such
analysis by using comparable salary data when determining adequate
shareholder compensation. We will ensure examiners comply with current
workpaper documentation requirements.
Recommendation 4:
Provide more specific guidance to shareholders and tax preparers, such
as that provided to IRS examiners, on determining adequate shareholder
compensation through means such as IRS's website.
Comment:
We agree to provide more specific guidance to shareholders and tax
preparers on IRS.gov.
[End of section]
Appendix V: GAO Contact and Staff Acknowledgments:
GAO Contact:
Mike Brostek (202) 512-9110 or brostekm@gao.gov:
Acknowledgments:
In addition to the contact named above, Tom Short, Assistant Director;
Jeff Arkin; Amy Bowser; Sara Daleski; Dewi Djunaidy; Elizabeth Fan;
Katie Freeman; Eric Gorman; George Guttman; Kara Marshall; Veronica
Mayhand; Brittni Milam; John Mingus; Karen O'Conor; Amy Radovich; David
Reed; Matthew Reilly; Anne Stevens; Meredith H. Trauner; Brian
Tremblay; Jim Ungvarsky; Walter Vance; Nick Weeks; and Jennifer Li Wong
made key contributions to this report.
[End of section]
Footnotes:
[1] This report does not address entities created under state law, such
as limited liability companies (LLCs), which may elect to be taxed as S
corporations or any of the three other federal business types. Most new
partnerships are LLCs.
[2] These figures are based on IRS's Statistics of Income (SOI) data.
All SOI dollar figures in this report are converted into 2009 dollars.
[3] Limited liability protection means that a shareholder's financial
liability for a company is limited to the amount of their investment in
the company. Generally, the shareholder's other personal assets cannot
be affected by the company's debts or by any lawsuits.
[4] Owners of S corporations are referred to as shareholders. The
percentage of stock (shares) owned by a given shareholder determines
his or her ownership stake.
[5] A distribution is any payment of S corporation funds to a
shareholder, including personal expenses paid by the corporation. A
distribution does not include wage payments or repayment of loans.
[6] The NRP studied reporting compliance for a random sample of tax
returns filed for tax years 2003 and 2004. IRS examined about 4,800 of
these returns to determine whether S corporations accurately reported
the income, expenses, and other items.
[7] This report uses the "net income (less deficit)" variable for all
net income figures, unless otherwise stated.
[8] Adjusted to 2009 dollars. For comparison's sake, net income for all
businesses grew by 62 percent and total assets grew by 44 percent over
the 2000 to 2006 period.
[9] Estimates for conversions are within +/-14 percent of the reported
values.
[10] IRS does not have data on conversions from S corporation to C
corporation status, but testimonial evidence indicates that this
happens infrequently.
[11] 26 U.S.C. § 1361(b).
[12] S corporation shareholders that are not individuals (e.g., trusts
and estates) fill out Form 1040 Schedule E, and are to attach it to
their respective tax forms (e.g., Form 1041).
[13] Shareholder claims of losses are also subject to at-risk
limitations - they may only claim losses for which they were
financially liable - and passive activity rules, which limit claiming
losses on business activities in which the shareholder did not
materially participate.
[14] Employers are required to withhold for individuals' federal income
taxes and Federal Insurance Contribution Act (FICA) taxes, which
includes Social Security and Hospital Insurance (Medicare Part A) taxes
on employees' wages. They are also required to match the amounts
withheld for an employee's Social Security and Medicare taxes, and to
pay Federal Unemployment Tax Act (FUTA) taxes on wages paid to
employees. Employees' federal income tax withholding, FICA, and FUTA
taxes are referred to as employment taxes. The tax rate for Social
Security is 12.4 percent of total wages and tips (as well as net
earnings for sole proprietorships and partnerships) up to a cap, which
was $106,800 for 2009. The tax rate for Medicare is 2.9 percent, with
no cap. Federal unemployment tax was 6.2 percent in 2009 on the first
$7,000 in earnings. Federal income tax withholding rates vary.
[15] See Rev. Rul. 74-44, 1974-1 C.B. 287.
[16] For an analysis of loss-taking by sole proprietors, see
[hyperlink, http://www.gao.gov/products/GAO-09-815], Tax Gap: Limiting
Sole Proprietor Loss Deductions Could Improve Compliance but Would Also
Limit Some Legitimate Losses (Washington, D.C.: Sept. 10, 2009).
[17] With self-employment tax, individuals pay all of the Social
Security and Medicare taxes. They get a tax deduction for half of those
payments. Limited partners generally do not pay self-employment taxes
on income allocated to them by the partnership, except for "guaranteed
payments."
[18] This reason for choosing S corporation status may be becoming less
important with the advent of the limited liability company (LLC). LLCs
are entities created under state law that provide similar limited
liability protection to a corporation while offering more flexibility
in other ways. An LLC may choose to be classified for tax purposes as
an S corporation, C corporation, partnership, or sole proprietorship.
[19] Pub. L. No. 99-514, 100 Stat. 2085 (Oct. 22, 1986)
[20] See Pub. L. No. 104-188, 110 Stat. 1755 (Aug. 20, 1996).
[21] Pub. L. No. 108-357, 118 Stat. 1418 (Oct. 22, 2004).
[22] The 68 percent estimate includes misclassification adjustments
where a taxpayer reports the correct amount but on the wrong line as
well as adjustments where the examiner zeroed out the entire return.
For comparison with S corporation misreporting, the NRP for individuals
estimated that 70 percent of sole proprietors in tax year 2001
misreported net business income. See Tax Gap: A Strategy for Reducing
the Gap Should Include Options for Addressing Sole Proprietor
Noncompliance, [hyperlink, http://www.gao.gov/products/GAO-07-1014]
(Washington, D.C.: July 13, 2007).
[23] All estimates from the NRP S corporation underreporting study
reflect the total over 2 tax years. From the S corporation NRP, 25
percent of the sample came from tax year 2003 and 75 percent from tax
year 2004, but both tax years 2003 and 2004 have equal input into our
estimates.
[24] We used Form 1120S, Schedule K, line 23 for tax year 2003 and line
17e for tax year 2004 to compute the items affecting S corporation net
income that flows through to shareholders.
[25] Estimate is within +/-12.2 percent of the reported value.
[26] This simplified calculation may be too high or too low. A precise
estimate would require tracing the S corporation noncompliance through
to the shareholder's income tax return to compute the ultimate tax
loss. Other factors that could affect the estimate include other income
and loss items on the shareholder return, the shareholder's ability to
claim any S corporation losses on the shareholder return, and income
taxes owed on shareholder's returns from inadequate wage compensation
provided to shareholders by S corporations.
[27] Net income is the most frequently misreported and largest
misreported line item overall because it is a cumulative line item that
is affected any time the items that contribute to it are adjusted.
[28] Other deductions include amortization; certain business costs;
insurance premiums; legal and professional fees; supplies; travel,
meal, and entertainment; and utilities.
[29] For more information about the extent of noncompliance with
shareholder compensation, see pp. 24-36.
[30] We reported in 2009 that 70 percent of sole proprietors reporting
losses in tax year 2001 had losses that were either partially or fully
noncompliant on the basis of NRP examinations. See GAO-09-815.
[31] Adjustments for S corporations with assets over $10 million, the
highest asset category, were not significantly different from those in
the under $250,000 category. An IRS official noted that the amount of
error as a percentage of their income was relatively low.
[32] Some S corporations also had multiple types of misreporting for
one line item.
[33] For example, the shareholder may not have had enough stock and or
debt basis to claim a loss from the S corporation or even if they had
basis, the at-risk rules may limit loss claims. At-risk rules look to
the source of funds. Passive activity losses are limited to passive
income. Passive activities are trade or business activities where the
shareholder does not materially participate during the year.
[34] EOAD had multiple entries of misreporting for a line item and we
could not reliably determine whether the examiner made a correction at
all, much less upward or downward, to the line item. IRS officials
could not tell us why this occurred or how to resolve these multiple
entries. This problem did not exist with the examination data from the
1120S NRP.
[35] GAO, Tax Preparers: Oregon's Regulatory Regime May Lead to
Improved Federal Tax Return Accuracy and Provides a Possible Model for
National Regulation, [hyperlink,
http://www.gao.gov/products/GAO-08-781] (Washington, D.C.: Aug. 15,
2008).
[36] 26 U.S.C. § 6694.
[37] GAO, Tax Administration: IRS Should Evaluate Penalties and Develop
a Plan to Focus Its Efforts, [hyperlink,
http://www.gao.gov/products/GAO-09-567] (Washington, D.C.: June 5,
2009).
[38] See section 403 of the Emergency Economic Stabilization Act of
2008, Pub. L. No. 110-343, 122 Stat. 3765 (Oct. 3, 2008); GAO, Capital
Gains Tax Gap: Requiring Brokers to Report Securities Cost Basis Would
Improve Compliance If Challenges Are Addressed, [hyperlink,
http://www.gao.gov/products/GAO-06-603] (Washington, D.C.: June 13,
2006).
[39] A capital account reflects each partner's equity in the
partnership, including each partner's capital contribution and profits.
[40] While not designed for the purposes of calculating basis, many
industry representatives told us that they can use the partnership K-1s
to track basis. The partnership K-1 includes checkboxes for the capital
account information, of which tax basis is one option. According to IRS
officials, even checking the other options would provide a rough
approximation for partnership basis.
[41] 26 U.S.C. §§ 3121(a) (FICA), 3306(b) (FUTA).
[42] 26 U.S.C. § 3121(d); Rev. Rul. 73-361, 1973-2 C.B. 331. However,
an officer of a corporation who does not perform any services or
performs only minor services and who neither receives nor is entitled
to receive, directly or indirectly, any remuneration is considered not
to be an employee of the corporation. 26 C.F.R. § 31.3121(d)-1(b).
[43] IRS will recharacterize distributions provided in lieu of an
adequate compensation for services performed by shareholders as wages
for employment tax purposes. Rev. Rul. 74-44, 1974-1 C.B. 287.
[44] Regardless of entity type, employers are required to withhold from
the wages of all employees, including corporate officers and others who
are paid to perform services, amounts for income tax liability and
employment taxes, and provide a matching share of employment taxes.
[45] 26 U.S.C. § 1401; 26 C.F.R. § 1.1401-4(c).
[46] For the 2-year total, the net $23.6 billion accounts for $24.6
billion in understated wages and $1 billion in overstated wages.
[47] Wages beyond the FICA maximum are subject to taxes for Medicare.
[48] Along with these constraints, this estimate could be high or low
due to other taxpayer filing errors that could increase or offset net
tax losses and could not be identified in our analysis. For example,
though very infrequent, taxpayers may have reported shareholder
compensation on the wrong line, which could distort underpayment
estimates.
[49] The estimates for each shareholder number group in Figure 2 will
not sum to $23.6 billion because $1.2 billion in adjustments were
associated with S corporations without a shareholder count. The
negative figure for the 4 or more shareholder group means that IRS
examiners determined that as a whole, this group was overpaid wages.
[50] Estimate is within +/-17.4 percent of the reported value.
[51] Treasury Inspector General for Tax Administration, Actions Are
Needed to Eliminate Inequities in the Employment Tax Liabilities of
Sole Proprietorships and Single-Shareholder S Corporations, Reference
no. 2005-30-080 (Washington, D.C.: May 20, 2005).
[52] IRS Fact Sheet, FS-2008-25 (August 2008).
[53] Treasury Inspector General for Tax Administration, The Internal
Revenue Service Does Not Always Address Subchapter S Corporation
Officer Compensation During Examinations, Reference No. 2002-30-125
(Washington, D.C.: July 5, 2002).
[54] Due to data limitations, we were only able to determine the number
of times that examiners looked at shareholder compensation and were
unable to determine how often an adjustment was made, or the amount of
the adjustment.
[55] Returns in the NRP study generally experience a higher level of
examination for certain noncompliance issues such as shareholder
compensation than during normal annual operations.
[56] Joint Committee on Taxation, Options to Improve Tax Compliance and
Reform Tax Expenditures, JCS-02-05 (Washington, D.C.: Jan. 27, 2005).
Following the rules for partnerships, this option would exclude certain
income such as rental income, dividends, and interest.
[57] JCS-02-05.
[58] Generally, service sector S corporations would include activities
such as health, law, engineering, architecture, accounting, actuarial
science, performing arts, or consulting.
[59] Joint Committee on Taxation, Additional Options to Improve Tax
Compliance (Washington, D.C.: Aug. 3, 2006).
[60] TIGTA 2005-30-080.
[61] Estimates are within +/-14 percent of the reported value.
[62] Adjusted to 2009 dollars.
[63] Amounts are adjusted to 2009 dollars.
[64] Median loss estimate is within +/-23 percent of the reported
value.
[65] Total dollar estimate is within +/-17 percent of the reported
value.
[66] Estimate for non-passive loss is within +/-25 percent of the
reported value, and estimate for passive loss is within +/-58 percent
of the reported value.
[67] Estimate for shareholders with multiple losses is within +/-37
percent of the reported value, and estimate for shareholders claiming
losses for only one S corporation is within +/-27 percent of the
reported value.
[68] Estimate for total losses is within +/-17 percent of the reported
value, and estimate for shareholders claiming losses for only one S
corporation is within +/-16 percent of the reported value.
[End of section]
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