The Internal Revenue Service (IRS) has made auditing partnerships and S corporations one of its top priorities.

In the past, the IRS audit rate for partnerships and S corporations has been very low—around 0.05% (or one out of every 200 returns). This audit rate is one-half the rate for individuals and one-quarter the audit rate for C corporations. In addition, about 50% of all partnership and S corporation audits in the past resulted in no changes to the tax return.

Now, the IRS has made auditing partnerships and S corporations a major priority as part of closing the “tax gap.” This increased enforcement could result in additional taxes, penalties, interest and potential criminal charges for taxpayers.

To start, some businesses may not even know that they are a “partnership” for tax purposes. For tax purposes, a “partnership” includes general partnerships, limited partnerships, limited liability partnerships, or limited liability companies (LLC) with more than one member. By default, all these entities are treated as partnerships for federal tax purposes.

S corporations are corporations that make a Subchapter S election by filing an IRS Form 2553. For both partnerships and S corporations, the businesses generally do not pay tax. Instead, the net income or loss from the business “flows through” to the business’s owners, who then pay tax on the income. This is why partnerships and S corporations are sometimes referred to as flow-through entities.

Here are some immediate steps that partnerships and S corporations can do to be ready for an IRS audit:

1. For partnerships, make sure that the partnership agreement (or LLC operating agreement) is ready for an IRS audit.

In 2018, the IRS’s new partnership audit rules went into effect. Many partnerships are not ready for these new rules. Congress changed the partnership audit rules with the Bi-Partisan Budget Act of 2015 (“BBA”). Every partnership agreement or LLC operating agreement should be amended to address the new issues from the BBA, including (1) naming a “partnership representative,” (2) deciding whether the partnership should elect out of the BBA audit rules, and (3) deciding how any additional tax will be paid—by the partnership or by its partners/members.

It is urgent that partnerships make these decisions before an IRS audit begins. These changes also should be made before any members or partners sell their interests in their business. This way, a selling member may be able to avoid a surprise tax bill years after they sell their interest.

2. For S corporations, is the business paying reasonable compensation to its officers?

For many closely-held businesses, the officers and owners of the corporation are also the main worker providing services for the business. If an officer provides services to the corporation (as an employee), then the corporation must pay officer compensation. Lack of officer compensation is one item that could increase the risk of an IRS audit.

In addition, that officer compensation must be “reasonable.” How much is reasonable? The IRS and courts look at many factors to determine reasonable compensation. The first hurdle is usually common sense. Compensation must be more than zero ($0), and it should be based on some reasonable steps (that is, not pulled out of thin air).

3. Are there any other risks that might trigger an audit?

The IRS has complex algorithms that help to determine whether a tax return should be audited. These algorithms produce a number—called the discriminant function score, or “DIF score.” The IRS keeps the criteria used to determine a DIF score a closely-guarded secret. However, the criteria include evaluating ratios of income to certain expenses, as well as comparing prior and subsequent year’s tax returns.

Are you concerned that your partnership or S corporation has issues that could trigger an IRS audit? The Former IRS Attorneys of Holtz, Slavett & Drabkin, APLC can review your situation from an IRS perspective and advise on changes to make before the IRS contacts your business.

Have you already been contacted by an IRS revenue agent about an audit? The Former IRS Attorneys of Holtz, Slavett & Drabkin, APLC represent clients in partnership and S corporation audits, as well as sensitive domestic and international tax examinations, litigation, employment tax cases, and difficult tax collection matters.

David J. Warner is a former IRS senior trial attorney. While at the IRS, David advised IRS revenue agents (auditors) on complex partnership and S corporation cases as a founding member of the IRS’s Southwest Area Partnership Cadre. David also taught partnership and S corporation taxation to IRS attorneys and to law students at Loyola Law School, UCI School of Law, and Chapman University Fowler School of Law. Please contact David at (949) 999-6606 to schedule a consultation.