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4 ways to cope with S corp audit blitz

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in Small Business Tax,Small Business Tax Deduction Strategies

The proliferation of S corporations has not gone unnoticed by the IRS. S corporations are now the most common corporate entity, accounting for nearly 60 percent of all corporate returns filed.

Now, the IRS wants to discover the biggest tax "noncompliance" areas for all those millions of S corporations. To do so, the IRS says it will subject 5,000 randomly selected S corporation returns from 2003 and 2004 to intense line-by-line audits. (IRS Information Release 2005-76)

"The use of S corporations has exploded," says IRS Commissioner Mark W. Everson. "The IRS needs a better understanding of what this means for tax compliance. This research is critical for achieving our strategic goal of ensuring that corporations and high-income individuals are paying their fair share."

Our advice: Stay calm. You can't do anything now that will affect your audit odds. If the IRS picks your name out of the hat, the best thing you can do is to prepare thoroughly for the audit (see steps on page 2).

However, if you operate an S corporation, recognize that the knowledge gained by the IRS through this program will help it focus more precisely on weak points in your company's tax returns if your business is audited in the future. So, if you're an S corporation tax-strategy gunslinger, the next few years may call for a bit more conservative approach.

S corporations under IRS microscope

First, let's look at what all the fuss is about. According to just released IRS figures, the number of S corporations nationwide jumped from 725,000 in 1985 to more than 3.1 million by 2002.

Furthermore, 2 million S corporations reported net income of $250 billion in 2002. Even more revealing, about 1 million S corporations reported net losses of approximately $63 billion. Obviously, the IRS is concerned that some S corporation shareholders are pulling the wool over their eyes.

The last time the IRS conducted a reporting compliance study of S corporations was in 1984, prior to the tax law changes that spurred the growth in S corps.

So, what can an S corporation owner do if the IRS comes knocking on your door to perform one of those painfully detailed audits? Follow these four recommendations:

1. Review the return(s) in question like you were studying for a college final. Be ready, willing and able to explain how you—or your tax return preparer—came up with any numbers that don't seem to jibe.

2. Assemble the records that substantiate the items on your return. Put the records in an orderly fashion, so you can access any particular report or receipt without an inordinate delay. You don't want to keep an IRS auditor waiting.

3. Remember that "neatness" counts. If you simply dump a pile of checks and records on an auditor's desk, don't expect any favors. In fact, the IRS agent may work a little harder at digging out suspect items.

On the other hand, if you make a neat and tidy presentation, you're more likely to score points. Most auditors are accountants by trade who will appreciate your organization and thoroughness.

4. Focus on the items that are a cause for concern. You probably know what they are. Support any suspect deductions with documentation and cited authority. You may have to do some research to back up a shaky position.

Final tip: It's wise to enlist the help of your tax pro right from the start, especially if your initial review of the return in question shows some holes.


During the audit, take your cues from your tax adviser. Don't try to be a hero by volunteering information that hasn't been requested.

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