The IRS has announced several new compliance campaigns focusing on S corporations. This is needed as the audit rate for S corporation is extremely low. The most recent IRS compliance campaign focuses on shareholder stock basis issues for S corporation owners. Those who have significant S corporation losses or large distributions should take time to review their records given this campaign.
About the IRS’s Campaign Approach
The IRS has limited audit resources. Given this limitation, it focus for IRS audits has long been to “touch as many returns as possible.” This “we are watching” approach is thought to encourage voluntary compliance by the greatest number of taxpayers.
The IRS has experimented with different ways to implement this policy over the past few decades. However, the Revenue Restructuring Act of 1998 limited some of the options for identifying problem tax returns. This included limiting the IRS’s ability to pull tax returns for audit based on the tax preparer or firm that signed off on the tax return.
The IRS has tried limited scope audits. It has tried organizing IRS audit groups by specialty function. It has tried requiring referrals to technical guidance coordinators and giving the coordinators review and concurrence oversight. It even tried organizing significant issues into tiers and pulling any return with those items on it. It has even experimented with recordkeeping agreements and other safe harbors.
Most of these initiatives have been abandoned or fallen out of favor by the IRS. The new focus is on compliance campaigns. These campaigns focus on one issue (or several related issues) and may include audits, sending warning letters, etc. The IRS publishes information about the campaigns in an effort to further its “we are watching” approach.
The IRS’s S Corporation Basis Campaign
This brings us to the S corporation basis campaign. The IRS describes the campaign as follows:
S corporation shareholders report income, losses and other items passed through from their corporation. The law limits losses and deductions to their basis in the corporation. LB&I has found that shareholders claim losses and deductions to which they are not entitled because they do not have sufficient stock or debt basis to absorb these items. LB&I has developed technical content for this campaign that will aid revenue agents as they examine the issue. The treatment streams for this campaign will be issue-based examinations, soft letters encouraging voluntary self-correction, conducting stakeholder outreach, and creating a new form for shareholders to assist in properly computing their basis.
The IRS also has two other related S corp campaigns. One is for several issues related to distributions and one is for S corp built in gains tax.
About S Corporation Basis
To understand this campaign, a quick review of the S corporation rules is in order.
S corporations generally do not pay tax. Rather, their net income or loss and other items pass through and are reported to the shareholder. The shareholder then reports these items on their personal tax returns.
This arrangement avoids the double tax on C corporations–which includes a tax at the corporate level and then potentially another tax at the shareholder level for distributions.
With this arrangement, the shareholder may be taxed on income it did not receive. This can happen in a number of situations. The most common is a profitable S corporation that simply opts not to make any distributions. In that case, the S corporation keeps the profits but the shareholder has to pay the “flow through” tax on the profit on their personal tax returns. The same thing can happen when the S corp sells property and does not distribute the gains to the shareholder.
The Shareholder’s Tax Basis in S Corporations
But let’s look at tax basis. A taxpayer’s tax basis in the entity is generally equal to the amount the shareholder contributed to the entity. It can also include debts the shareholder is liable for on behalf of the S corporation, such as debts the shareholder personally guaranteed. The taxpayer’s basis is increased by profits and decreased by losses. It is also decreased by distributions.
Tax basis can lead to a number of tax issues. The most common are S corporation losses in excess of shareholder tax basis. The rules do not allow a shareholder to take losses in excess of tax basis. Taxpayers may inadvertently report the flow through losses on their personal tax returns even though they do not have sufficient tax basis to take the loss.
Another issue is distributions in excess of basis, which are not reported as taxable income. The shareholder may believe that the distributions are a return of capital investment and not report the distributions as taxable.
Other S corporation basis issues involve tax planning techniques. Whether it is a S corporation value freezes, basis shifting, employee benefits and shareholder compensation, or even leveraged debt transactions. The IRS is likely to review these transactions closer as it focuses in on tax basis issues for S corp shareholders.
Missing Information and Estimates
As a practical matter, this may happen either because the taxpayer is not aware of the rules or the taxpayer did not have sufficient information to know what his basis in the S corporation is.
The last point is problematic. Taxpayers often do not keep records of the adjustments needed to compute their tax basis. This is particularly true for businesses that have been S corporations for a long time. Tax basis is a running calculation. It is one that starts from the very day the business makes it’s S corp election.
Tax preparers will often rely on past tax returns to recompute shareholder basis. This is only possible when the prior tax returns are available. Even the IRS does not keep most tax returns for more than 3-4 years. So if the taxpayer is not able to locate the tax returns, the tax preparer has to make estimates based on the last known information. This can be quite complex. It can include estimating loan payments, gain, etc.
Presumably this IRS campaign will find losses in excess of basis. It may also find distributions in excess of basis that are taxable, but not reported. We see this as tax attorneys in Houston with the high profit services that cater to the oil and gas industry. Many of these Houston businesses are structured as S corporations and they have periods of boom-and-bust, years of high income followed by years of losses. That is the nature of the economy in the Houston metro area.
Taxpayers who have flow through losses from S corps and significant distributions may want to review their shareholder basis calculations in advance of an IRS audit resulting from this campaign. This is particularly important for S corporations with assets of $10 million or more, as they are more likely to be the subject of this campaign.