Faris R. Fink, IRS commissioner of the Small Business and Self-Employed Division, announced that 2014 will be the year the IRS moves its examination focus from C corporations to flow-thru entities. A flow-thru entity is any business whose tax is imposed at the owners’ level, on their individual income tax returns. Such entities include partnerships, limited liability companies, and S corporations.
In 2011 the average audit rate for corporate and individual returns was about 1%. For flow-thru entities, it was about 0.4%, reflecting the IRS’s long-standing focus on corporations. Given the rising number and complexity of flow-thru entity returns, however, the IRS believes that the level of noncompliance, unintentional or otherwise, needs to be more formally addressed. Flow-thru returns also provide a gateway to examining the owners’ individual returns and related entities.
Past efforts at targeting the noncompliant, while not imposing exam-induced hardships on the innocent, has been a challenge for the IRS. Various TIGTA (Treasury Inspector General for Tax Administration) found that the incidences of no-change exams was over 50% for flow-thru entities, significantly higher than for individuals and corporations.
While the IRS works out how they are going to do a better job at selecting returns more likely to bear fruit, we expect agents to concentrate on the following, among other areas:
- Basis substantiation
- Related party transactions, including loans
- Probe for personal expenses buried in deductions on the business return
- Compliance with required disclosures
- Allocation of income
- Treatment of withdrawing partners
Submitting a tax return to the IRS is the first step in a potentially disastrous relationship. Investing the time necessary to prepare a return that will withstand IRS scrutiny is the best defense, not only to achieve a no-change audit but to also eliminate the risk that other returns will be pulled into the exam. At minimum, you should understand what aspects of the return carry risks of an adverse finding, and make an informed decision on those tax positions prior to filing.
For further information or to discuss your specific situation, please contact your Aronson tax advisor at 301.231.6200.