S Corporations, Complexity and the Tax Gap
A recent GAO report indicates a high rate of errors on S corporation returns.
January 28, 2010
Many types of errors contribute to our $345 billion annual tax gap. The Government Accountability Office (GAO) released a report in December 2009 estimating what S corporations and their shareholders contributed to this gap. The report indicates the types of errors and makes recommendations for improvement. This article reviews data on S corporations, summarizes the GAO report and makes observations on the relevance of this information to tax reform.
S Corporation Data
The GAO report, Actions Needed to Address Noncompliance with S Corporation Tax Rules (GAO-10-195; December 15, 2009), points out that S corporations have been the second fastest growing business entity form (partnerships are first). From 2000 to 2006, the number of S corporations increased 35 percent compared to 23 percent for all business types. A significant cause of this growth was the conversion of C corporations to S corporations. In 2006, S corporations accounted for almost 13 percent of all businesses (GAO report, pages three to four, 43). IRS data indicates that for 2006, almost four million S corporation returns were filed representing interests of almost 6.7 million shareholders (SOI data on Form 1120S). In 2006, 66.3 percent of all U.S. corporations were S corporations, yet represented just 21.2 percent of total corporate receipts (IRS, SOI Bulletin (PDF), Vol. 29, No. 1, Summer 2009, page 92).
Accompanying the growth in numbers was a growth in net income generated. From 2000 to 2006, net income of S corporations increased by 67 percent while total assets increased by 46 percent.
The majority of S corporations have less than four shareholders. In 2006, 60 percent of S corporations had only one shareholder while 89 percent had two or less and 84 percent had three or less (GAO report, page four).
Reasons for Popularity
Two significant reasons for the popularity of S corporations are limited liability afforded by the corporate status and the passthrough status of this entity. The GAO estimates that for 2001, 42 percent of S corporation shareholders used an entity loss to offset other income on their Form 1040 (GAO report, page eight). An advantage the S corporation holds over a partnership or sole proprietorship is that only wages paid are subject to employment tax rather than total income being subject to self-employment tax.
In addition, changes by the Small Business Job Protection Act (SBJA) of 1996 to increase the number of allowed shareholders from 35 to 75 and broadening the type of taxpayers who could be shareholders likely contributed to the popularity of this entity form. The further increase in the number of shareholders to 100 by the American Jobs Creation Act of 2004 provides more corporate entities with the option to elect S status.
Given the long history of some S corporation issues, namely payment of reasonable compensation to the shareholder/employees, it is not surprising that the GAO found this to be a problem area that creates a payroll tax gap. Surprising though is the high percentage of Forms 1120S with reporting errors and the number of such returns completed by paid preparers.
The GAO reports that about 68 percent of Forms 1120S for 2003 and 2004 misreported at least one item relevant to proper calculation of income. Combining errors of over- and under-reporting, the errors passed through to shareholders totaled approximately $85 million. The GAO extrapolates this to easily being a minimum of an $8.5 billion tax gap for these two years assuming a low tax rate of 10 percent. Significant errors were found in reporting of sales, other deductions, distributions and shareholder compensation. In a review of 166 randomly selected Forms 1120S for 2003 and 2004, the GAO found that improperly deducting personal expenses was also a common error. (GAO report, pages 10 to 14)
IRS data indicates that for 2003 and 2004, inadequate wage compensation was a problem for about 13 percent of S corporations. This problem equated to about $24 billion of missing wages and about $3 billion of lost payroll taxes for the two years. Adequate compensation problems were more common in S corporations with few shareholders. (GAO report, page 25)
The Treasury Inspector General for Tax Administration (TIGTA) released a report in 2005 that was quite blunt in its assessment of compensation issues with S corporations. The report highlighted employment tax differences between sole proprietors and S corporations, particularly those with a single shareholder. TIGTA observed: "the S corporation form of ownership has become a multibillion dollar employment tax shelter for single-owner businesses." (Actions Are Needed to Eliminate Inequities in the Employment Tax Liabilities of Sole Proprietorships and Single-Shareholder S Corporations, May 2005)
Forms 1120S with errors were not limited to self-prepared returns. The GAO found that about 71 percent of Forms 1120S completed by a paid preparer had errors compared to 75 percent for self-prepared forms. (GAO report, page 15)
Another error noted by the GAO, but without sufficient data to generate a reasonable estimate, stems from shareholders reporting losses on their returns beyond the shareholder's stock and debt basis.
IRS examination of S corporations is low with less than 0.5 percent examined in fiscal year 2008 (GAO report, page 17). GAO also noted that examination of shareholder compensation is lower; it occurred in less than 25 percent of the examinations (GAO report, page 28).
Based on the nature and frequency of particular errors at the entity and shareholder level, the GAO made the following recommendations (GAO report, pages 19 to 23, 37).
While the shareholder salary recommendations seem quite minimal given the longstanding and sizeable nature of the problem, the GAO report did discuss various legislation options, each with its advantages and disadvantages, including that some might undermine other advantages offered by the S corporation status. The GAO's legislative options are noted in Table 8.
In its 2005 report (noted earlier), TIGTA recommended that Treasury and the IRS re-evaluate Revenue Ruling 59-221 which TIGTA viewed as outdated because it was based on the assumption that most S corporations would have several shareholders. TIGTA suggested either through regulations or legislation, to "subject all ordinary operating gains of an S corporation that accrue to a shareholder (including the shareholder’s spouse and dependent children) holding more than 50 percent of the stock in the S corporation to employment taxes." This recommendation was not included in the GAO report.
The GAO report not only highlights tax gap contributions of S corporations and their shareholders, but also complexity and audit challenges inherent in many of our tax rules. Some of these problems likely can be addressed through improved efforts to educate taxpayers and preparers. The IRS has increased the amount of information it provides via its Web site. For example, it has a page devoted to S corporations that explains the rules on compensation and basis. In addition, Fact Sheet 2008-25 explains the rules on adequate compensation of S corporation shareholder and provides factors to help in determining proper compensation. The IRS needs, though, to find ways to get more taxpayers and preparers to make use of the vast amounts of information it provides on its Web site.
In addition, the IRS announcement in January 2010 of new efforts to regulate all paid preparers presents the option of better ensuring that those preparing Forms 1120S are well-versed in S corporation rules.
The complexity of determining adequate compensation and tracking shareholder basis are longstanding problems. The GAO and TIGTA suggestions that Congress also get involved in finding solutions are thus appropriate and should be part of their continuing efforts to reduce the tax gap.
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Annette Nellen, CPA, Esq, is a tax professor and director of the MST Program at San José State University. Nellen is an active member of the tax sections of the AICPA, ABA and California State Bar. She serves on the AICPA’s Individual Income Taxation Technical Resource Panel and chairs the California Bar's Tax Policy Committee. She has a 21st Century Taxation Web site and blog.