Over the past few years, a majority of IRS audits of S corporations have resulted in no changes. That's the conclusion of a recent report by the Treasury Inspector General for Tax Administration (TIGTA). TIGTA provides independent oversight of IRS activities. While learning that their returns wouldn't be changed probably came as a relief to those business owners whose firms were audited, the statistics also reveal that the IRS may be using its resources to look at returns that really don't need examination.

The June report, "The Recommended Adjustments from S Corporation Audits Are Substantial, but the Number of No-Change Audits Is a Concern," indicates that 62 percent of S corporation audits for fiscal year 2011 were closed without any changes. As the report points out, "a high no-change percentage means the IRS is spending a significant amount of resources on unproductive audits and burdening compliant taxpayers with unnecessary audits." Between 2007 and 2011, the IRS' Small Business/Self Employed division audited 53,544 S corporation returns.

The returns had been selected for audits based on the score they received from the IRS' Discriminant Index Function (DIF), which uses mathematical formulas to calculate scores for returns based on their audit potential. The IRS, not surprisingly, keeps pretty quiet about the variables that make up the DIF. However, according to a 2005 paper by a University of Chicago law school professor, "Against Prediction: Sentencing, Policing and Punishing in an Actuarial Age," the DIF is "based on multiple regression analysis of past audits intended to identify the key factors that are most likely to indicate tax fraud." It does this by comparing one return against others in the same income bracket and profession and then identifying those that fall far outside the average. The DIF also reportedly picks up on red flags -- say, a high number of deductions -- and includes those in the score.

S corporations have recently come under greater scrutiny. One reason is simply the growth in this type of business entity; according to the report, the number of S corp returns has quintupled since 1984. The income generated by S corporations is growing as well; overall S corporation gross income in 2008 was $6.1 trillion, up nearly 70 percent from the $3.6 trillion recorded in 2000. In addition, many S corporations are controlled by one or just a handful of individuals, creating greater opportunity for transactions to be structured to avoid income taxes, the report notes. All this means that the number of S corp audits likely will grow.

At the same time, the process improvements recommended by TIGTA may increase the percentage of audits that are changed. The report recommends that IRS researchers suggest alternative audit selection methods and "identify additional productive returns for audit." They also can take additional steps to strengthen controls over the way in which returns are classified.

In its response to the report, the IRS indicated that it would work to better identify S corporation returns for audit, and would revise its classification guidelines to obtain a balanced review of various types of returns.

Related Articles:

Tax Planning, Given the Likely End of Bush Tax Cuts
What to Expect from the Upcoming Medicare Tax