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TAX UPDATES > E-Alert: Government Accounting Office Puts Spotlight on S Corporations
In recent years, S corporations have been recognized as one of the fastest growing business types, with four million businesses choosing to operate under this form. Congress feels that along with the proliferation of S corporations come problems in the tax compliance. As a result, the Government Accounting Office (GAO) was asked to analyze S corporation filings and report to Congress on the potential revenue loss.
The GAO reviewed a sample of S corporation returns filed for the years 2003 and 2004. They also reviewed reports prepared by the IRS following their examination of S corporations in field audits. The most common issues discovered were i) inadequate compensation of shareholders, ii) underreporting of income, and iii) the deduction of losses by shareholders in excess of their tax basis. GAO also recommends actions to be taken by Congress and the IRS to close the S corporation tax gap.
Inadequate Compensation of Shareholders
The concern with inadequate compensation is considered to be the most prevalent due to the underreporting of payroll taxes. S corporation shareholders who are not adequately compensated for their services still pay an appropriate amount of income tax. The GAO estimates, however, that as much as
$3B of revenue per year is lost as a result of this issue. The suggested remedies range from taxpayer education conducted by the IRS to legislative correction in the form of subjecting S corporation profits to self-employment or payroll taxes.
Underreporting of Income
The GAO focused on the areas of deduction of ineligible expenses and misreporting of sales or cost of goods sold. The most frequent error was stated to be the deduction of ineligible, personal expenses such as automobiles, insurance premiums, travel, meals and entertainment. The report recommends taxpayer education and increased imposition of penalties on taxpayers and return preparers as the cure for this problem.
Deduction of Losses in Excess of Shareholder Basis
The S corporation rules limit the deduction of losses to the shareholders' tax basis, and many shareholders fail to track their tax basis or are otherwise unaware of this limitation. The GAO recommends that Congress legislate mandatory reporting of shareholder basis, forcing S corporations to gather the information and to report it to shareholders on the Schedule K-1's along with their share of profit and loss.
In summary, it’s obvious that Congress perceives problems with the tax gap in the S corporation area, and the IRS agrees with this analysis. Look for action on the part of both in the form of legislation and increased examination activity to fill the gap.
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