Tax Gap: Actions Needed to Address Noncompliance with S Corporation Tax Rules
Highlights
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.
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.
Recommendations
Matter for Congressional Consideration
| Matter | Status | Comments |
|---|---|---|
| To improve compliance with shareholder basis rules, Congress may wish to 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. | No legislative action has been identified. As of March 2024, Congress had not enacted legislation to require S corporations--a federal business type that provides certain tax benefits like passing income and losses to shareholders' individual returns--to calculate and report shareholders' stock and debt basis as completely as possible and report the calculation to shareholders and IRS, as GAO suggested in December 2009. Shareholders who do not properly track and report their basis may overclaim losses passed to them from the S corporation and improperly offset other taxable income. Congressional action requiring S corporations to report basis information to shareholders and IRS could improve compliance with basis rules and help ensure S corporation shareholders pay taxes owed. |
Recommendations for Executive Action
| Agency Affected | Recommendation | Status |
|---|---|---|
| Internal Revenue Service | To help address the compliance challenges with S corporation rules, the Commissioner of Internal Revenue should 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. |
IRS had been developing a long-term research plan that will study the impact of improving preparer requirements, including those that return preparers who prepare S corporation returns. As a result, IRS has initiated a project to identify potential preparer noncompliance of flow-through returns, including S corporation returns.
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| Internal Revenue Service | To help address the compliance challenges with S corporation rules, the Commissioner of Internal Revenue should 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. |
The Director, Examination Policy, agreed to modify the correspondence sent out upon acceptance of an S corporation election to include language on S Corporation shareholder's responsibility for maintaining stock and debt basis, and direct them to additional resources, including the IRS.gov website, on these and other tax obligations. Further, IRS informed GAO in December 2010 that IRS has been updating their website to include more specific guidance on tracking and calculating basis for S corporations. In March 2011, The Director, Examination Policy, agreed to modify current correspondence sent out upon acceptance of an S election to include language on S Corporation shareholder's responsibility for maintaining stock and debt basis, and direct them to additional resources, including the IRS.gov website. In November 2011, IRS told GAO that it planned to work on guidance on S corporation requirements such as on basis and compensation during 2013. In November 2012, IRS created modifications to a letter that provides guidance for new S corporations, such as requirements on basis; however, due to other priorities, IRS staff said that this letter will not be processed until 2013. In January 2013, in the two notices that are used to inform the corporation that the S election has been accepted, IRS has included language indicating they should inform shareholders of their need to track stock and debt basis. One notice also guides readers to S corporations resources on IRS.gov. In addition, the IRS.gov S corporation web page has been updated and includes information regarding the shareholder's responsibility of tracking stock basis. http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/S-Corporations.
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| Internal Revenue Service | To help address the compliance challenges with S corporation rules, the Commissioner of Internal Revenue should require examiners to document their analysis such as using comparable salary data when determining adequate shareholder compensation or document why no analysis was needed. |
Exam Policy published an article in the August issue of the Exam Technical Digest reminding examiners of the importance of addressing adequate shareholder compensation and the need to document such analysis(including the use of comparable salary data) in the workpapers when compensation is a large, unusual, or questionable item during the audit.
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| Internal Revenue Service | To help address the compliance challenges with S corporation rules, the Commissioner of Internal Revenue should 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. |
As of September 2014, IRS had updated their website to include more guidance on shareholder compensation. IRS stated in their 60 day letter they already did this. We originally disagreed because we wanted them to provide MORE guidance. On the IRS website, which was last updated in September 2014, IRS cites some court cases, ranging from 2001 to 2012, about determining the reasonableness of compensation. For example, the 2012 case was on reasonable reimbursement for services performed.
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