GAO-11-318SP: General government: Congress and IRS can help S corporations and their shareholders be more tax compliant, potentially increasing tax revenues by hundreds of millions of dollars each year

General government

Congress and IRS can help S corporations and their shareholders be more tax compliant, potentially increasing tax revenues by hundreds of millions of dollars each year

Why Area Is Important

The number of S corporations—corporations with no more than 100 shareholders that meet certain other requirements—has grown steadily in recent years, reaching around 4 million with over $400 billion in total net income. S corporation status provides liability protection to shareholders.

S corporations' income gains and losses "pass through" to shareholders who are to report these passed-through amounts on their individual income tax returns. Shareholders are allowed to claim S corporation pass-through losses up to the amount of their basis in an S corporation (value of their investment). Shareholders are to track basis changes, which can arise from their actions, like new investments in the corporation, or S corporation actions, like reinvesting profits.

S corporations can pay shareholders wages and make nonwage distributions, like dividends, but employment taxation only applies to the wages. The Internal Revenue Service (IRS) requires S corporations to pay reasonable wages to shareholders who perform services, and if they do not, employment taxes can be improperly avoided.

What GAO Found

According to IRS's most recent research, for tax years 2003 and 2004, 68 percent of S corporation returns misreported net income. As a result, S corporations passed through an estimated $85 billion less taxable income to their shareholders than should have occurred. IRS's research did not cover how the shareholders treated this misreported S corporation income on their individual tax returns. However, applying the lowest individual income tax rate of 10 percent to this S corporation misreported amount suggests that S corporation shareholders could have underpaid their income taxes by $8.5 billion over those 2 years. IRS does not know the reasons for this misreporting, which could be intentional attempts to improperly lower tax liability for individual shareholders or unintentional errors due to confusion over what to report.

Shareholders of S corporations are required to track their basis, but have made mistakes in that area. For fiscal years 2006 through 2008, IRS examiners found that shareholders, on average, claimed about $21,600 in losses that exceeded their basis in the S corporation. These overclaimed losses could reduce taxes on the taxpayers' other income. IRS views basis as a common issue on shareholder returns. In particular, shareholders of new S corporations are less likely to understand the requirement to track and calculate basis. One factor contributing to basis noncompliance is that S corporations are not required to calculate shareholder basis and report it to shareholders and IRS, even though S corporations have information that shareholders could use to calculate basis. In addition, IRS does not send new S corporations and their shareholders information alerting them to the necessary record-keeping requirements

Unlike other businesses, S corporations can improperly lower employment tax liabilities by paying shareholders who perform services less in wages and more through other means, like profit distributions. For tax years 2003 and 2004, IRS estimated that 13 percent of S corporations underpaid a net of $23.6 billion in wages. To illustrate the potential loss of revenue to the government, applying the maximum Federal Insurance Contributions Act tax rate of 15.3 percent to the net underpayment amount roughly equates to $3 billion in employment tax losses. The vagueness of federal tax law as well as IRS and Department of the Treasury guidance on determining adequate shareholder wages make employment tax evasion difficult to control. Nearly all of the stakeholder representatives GAO interviewed indicated that having clear and specific IRS guidance would be helpful for taxpayers and preparers. IRS has some training materials for its examiners that go beyond published guidance, but those materials are not available for S corporations.

IRS examinations of S corporations' wage payments could be more effective. In the sample that GAO reviewed, when IRS examiners used tools like Bureau of Labor Statistics data on compensation, they tended to more frequently identify underpayment of wage income. IRS does not require use of such tools nor does IRS require its examiners to document the analysis done to support their compensation determinations or why an analysis was not done.

Paid preparers had little impact on S corporation compliance as the overall misreporting rate was about the same whether or not an S corporation used a paid preparer. Some stakeholders GAO interviewed thought some preparers lacked the expertise needed to address S corporation tax issues. IRS has begun regulating all paid tax return preparers and could begin requiring preparers to pass competency examinations. This may be a way to improve preparers' ability to adequately handle S corporation returns.

Actions Needed

As GAO reported in December 2009, to improve basis compliance, Congress could require S corporations to use information already available to them to calculate shareholders' basis as completely as possible and report it to shareholders and IRS.

Furthermore, GAO recommended in December 2009 that IRS require examiners to document their compensation analyses and their use of comparable salary data when determining adequate shareholder compensation. IRS took steps by publishing an article in August 2010 reminding examiners of the importance of addressing adequate shareholder compensation and the need to document such analysis.

As of December 2010, IRS is considering or taking action on other recommendations included in GAO's December 2009 report, but none of them have been implemented. GAO recommended that IRS should evaluate options for improving paid tax return preparer performance, send additional guidance on S corporation requirements such as on basis calculations and adequate wage determinations to new S corporations, and provide more guidance to shareholders and tax preparers on determining adequate shareholder compensation. The effect of implementations should be improved tax compliance by S corporations and their shareholders. Although an estimate of potential revenue increases from improved compliance is not available, a small decrease in the billions of dollars of income and wage underreporting could increase tax revenues by hundreds of millions of dollars each year.

Framework for Analysis

The information contained in this analysis is based on the related GAO product listed under the "Related GAO Products" tab.

Area Contact

For additional information about this area, contact James R. White at (202) 512-9110 or