The IRS’ Large Business and International (LB&I) Division has several active campaigns targeting S corporations. LB&I handles business entities reporting assets in excess of $10 million. The purpose of audit campaigns is to identify potential noncompliance areas to focus on issue-based examinations and allocating their tax examination resources to taxpayers that will likely yield more tax revenue.
There are numerous campaigns going on at any given time, with that information freely available on the IRS’ website. The specific campaigns targeting S corporations are:
Distributions – These are tax-free to the shareholders to the extent of basis, and it is all too common for taxpayers to make the assumption that this is the case. However, that assumption is the impetus for this campaign. The IRS has identified three issues:
- Distributions in excess of basis are taxable. It is crucial that shareholders maintain their own basis schedule. The IRS made a change starting with the 2018 tax forms, requiring that the basis schedule be included with the individual tax return filing.
- Distributions of appreciated property is reportable as a gain by the S corporation as if the corporation sold it for fair market value.
- Distributions made by an S corporation that was formerly a C corporation requires additional analysis to determine if the payment is properly allocable to the AE&P carried over from the C corporation years.
Losses – Shareholders may deduct losses up to their basis. Losses in excess of basis is suspended and carried over to a future year, usable against future basis. As is the case with distributions, shareholders must attach a basis computation to their individual tax return when claiming a loss.
Built-in Gains – When a C corporation converts to an S corporation, the unrealized gains and profits in existence at the time of conversion create a potential tax liability of the S corporation recognizes this income within 5 years of conversion. Such income is taxed as if the company was a C corporation, at the highest tax rate (which at present is a flat 21%). Upon conversion, the S corporation must calculate the built-in gains and track each identified asset over the 5-year period, appropriately recognizing income upon disposition within this period.
The filing of a tax return is the first step in a potentially adversarial relationship with the IRS. It is not enough to merely prepare the return – it should be read with an eye for the obvious and not so obvious elements that could flag the return for an audit.
For further information about this and other potential audit matters, please contact Aronson’s tax controversy partner Larry Rubin at 301.222.8212.