Over the next two years, at least some owners of S corporation businesses, one of the most popular tax classifications for small business proprietors, will find their tax returns scrutinized far more carefully. The Internal Revenue Service has begun a study of these types of businesses to determine whether these owners have been paying their fair share of taxes and to develop guidelines to help the agency ensure future compliance. “We want to make sure that corporations and high income individuals are paying their fair share,” said Victor Omelczenko, an IRS spokesperson. “We’re not just going after under-reported tips anymore.” Only 5,000 filers from tax years 2003 and 2004 will be included in this initial audit, part of a larger effort to close what the agency calls a tax gap between what is paid and what is actually owed. But the results of the study will be used to earmark those returns that should receive added scrutiny in the future. The move comes as the number of S corporations, a type of business classification most often used by small businesses with 100 or fewer shareholders, has grown significantly. As of 2004, there were 3,503,932 S corporations in the country, up from 3,154,377 in 2002 and 724,749 in 1985. California ranks third in the country after Florida and New York for its numbers of S corporation businesses. The classification has gained popularity because businesses are taxed not on the income of the company but on the income of the individual shareholders. In effect, these business owners pay taxes on the salaries they are paid from the corporation, posing a less onerous tax burden than they would incur if they were required to pay taxes on their business income. But while the classification helps small business owners who might wish to put profits from the company back into the business in order to build it, it can also leave a lot of wiggle room for those who see it as a way to avoid paying taxes. “There are some creative people that determine that, ‘let’s call this income from the company instead of wages,’ ” said Sharon Sanders, a tax specialist for the IRS. “Wages are subject to employment taxes. If it’s income, it’s not subject to employment taxes. Some people apply what should be wages to income.” The audit will look at such things as how much a business owner who works at the business collects in salary to make sure that it is consistent with what that type of worker would earn at another company. If, for example, a dentist whose practice was classified an S Corporation paid himself $20,000 in wages, that would not pass muster. Proper payment “When we do this kind of audit, it’s line by line. We want to develop a profile of S Corporations,” said Sanders. “One of the things we are alert to is how the money is paid out. We frequently have officers that are actively engaged in the corporation, and so what we look at is to make sure that the corporation is paying the person working there as though they were a regular employee.” These audits, along with earlier ones, are part of the agency’s National Research Program (NRP), created in 2000 to measure compliance in a variety of different tax categories. The first such study, aimed at individual taxpayers and completed last year, found a tax gap estimated at more than $300 billion each year. But it also spurred criticism because it focused, in some cases, on low income earners. “There was a huge outcry for (the audit on) earned income tax credit,” said Sanders. “People said, why are you just picking on low income people. So we’re looking for tax dollars in all the places where we can find them.” These stepped up efforts seem to be helping fill the IRS coffers. Enforcement revenue Last year, the agency brought in what it called a “record” $43.1 billion in enforcement revenue, 15 percent more than it did in 2003. The number of individual taxpayers audited in 2004 topped 1 million for the first time since 1999, the IRS said. Total audits of individuals rose 19 percent over 2003 and audits of what the IRS calls high-income taxpayers, those earning $100,000 or more, increased 40 percent over 2003 to a total of 195,000 such taxpayers. But audits of small business, those with less than $10 million in assets, have been declining in recent years, and the IRS has said it wants to step up its scrutiny of those firms. Most accountants in the local area said that they are not worried about the additional scrutiny. Many of their clients, they say, are wealthier individuals, and audits on high-wealth individuals are a fact of life. “I’ve lived through a lot of cycles of the IRS making a lot of announcements,” said Tony Rose, CEO of Rose, Snyder & Jacobs in Encino. “The announcement is always scarier. Most of the clients that engage good (CPA) firms have nothing to worry about. Audits are audits. It’s a fact of life.”
