The Number of No-Change Audits Is a Concern

Editor: Valrie Chambers, Ph.D., CPA

Procedure & Administration

On June 20, 2012, the Treasury Inspector General for Tax Administration (TIGTA) released two reports for its study of the Small Business/Self-Employed (SB/SE) Division audits of partnerships and S corporations (Rep’t Nos. 2012-30-060 and 2012-30-062, respectively). The findings in both TIGTA audits are similar. Each states that although the SB/SE audits recommended substantial adjustments, roughly 33% of all the audits in fiscal years (FYs) 2009–2011 resulted in no change. While this is probably not a surprise to many practitioners, the TIGTA reports do offer some interesting insights into possible improvements in the audit selection process.

While the IRS has developed many resources to select returns for audit, perhaps the best-known one is the discriminant index function (DIF) system. The IRS has for years relied on this system to decide how to best allocate its audit resources. The system uses mathematical formulas to score returns based on their audit potential. The higher the score, the more an audit is considered likely to result in changes to the return.

However, TIGTA found that DIF-selected returns had high no-change rates: 50% for partnerships and 62% for S corporations in FY 2011. This means that the IRS is spending significant time and resources on unproductive audits and unnecessarily burdening compliant taxpayers. In contrast, in FYs 2009–2011, 19% of S corporations (Rep’t No. 2012-30-62, p. 5) and 17% of partnerships (Rep’t No. 2012-30-60, p. 6) selected for audit because of an abusive transaction were no-change audits. Returns selected for audit from sources other than DIF or abusive transactions also had lower no-change rates, ranging from 27% to 40% (Rep’t No. 2012-30-062, Figure 2; Rep’t No. 2012-30-60, Figure 3). Other sources include IRS studies and projects designed to focus on specific areas of suspected noncompliance other than abusive transactions.

When examiners do recommend adjustments, the amounts are significant. For each S corporation audited in FYs 2007–2011 (including those for which there was no change), recommended adjustments averaged $105,534 (Rep’t No. 2012-30-062, p. 3); for each partnership audited in FY 2011, recommended adjustments averaged $137,000 (Rep’t No. 2012-30-060, p. 5). Interestingly, due to systems limitations, neither the IRS nor TIGTA knows for certain how much additional tax was assessed based on the examiners’ recommended adjustments.

How to Improve Audit Productivity

TIGTA found that improvements to the DIF system are not likely in the near future. Although the most recent previous partnership study was for tax year 1981, due to budget constraints, the IRS has no plans to collect and study the compliance data needed to update the system for selecting partnership returns for audit. The IRS completed a National Research Program (NRP) study of S corporations in FY 2008 and did develop an improved DIF formula using the new data. However, NRP officials told TIGTA that they have not made any plans to assess the effectiveness of the new formula.

In response, TIGTA suggests that the IRS pursue alternative selection methods by using existing databases containing S corporation and partnership information. To illustrate the potential of this approach, TIGTA used the Business Return Transaction File, which contains all the transcribed items from S corporation and partnership returns, and the Audit Information Management System, which contains S corporation and partnership results, to determine whether the characteristics of S corporations and partnerships with audit adjustments might provide leads to additional returns that were not selected for audit.

TIGTA’s analysis found that audits of construction or real estate partnerships with two partners and a reported loss were very effective in terms of proposed adjustments. They found 321 audited returns that resulted in proposed adjustments of $671,000 per return on average. In comparison, DIF-related returns had recommended adjustments of $89,000 per return (Rep’t No. 2012-30-60, p. 8). Results were similar in the study of S corporations. TIGTA looked at S corporations with one shareholder and losses of at least $25,000 in three or more consecutive years. These returns produced recommended adjustments of $91,861, compared with $46,924 for the remaining audits (Rep’t No. 2012-30-62, p. 8).

Other Findings

S corporations are a fast-growing segment of all returns filed. In processing year (PY) 2011, S corporations filed almost 4.5 million returns, which is more than double those filed by C corporations and an 80% increase over PY 1997. The IRS estimates that nearly 5.7 million S corporation returns will be filed in PY 2015 (No. 2012-30-62, p. 4).

The majority of S corporations and many partnerships are owned by few shareholders or partners. TIGTA maintains this is a compliance risk, as these owners can control day-to-day operations and management in general and can improperly structure transactions to reduce income taxes they might otherwise owe. TIGTA points to the growth of abusive transactions, from 10 identified in published IRS guidance in 2000 to 34 as of January 2012, as an area of special concern, since several of these abusive transactions relate to S corporations and partnerships.

TIGTA also evaluated a “judgmental” sample of the partnership and S corporation audits done in FY 2009 by the SB/SE. While a judgmental sample is nonstatistical and cannot be used to draw conclusions about the population as a whole, the findings are still informative. TIGTA made recommendations in earlier reports regarding quality concerns surrounding issues on related returns (TIGTA Rep’t Nos. 2011-30-084 and 2011-30-113). Thus, it can be assumed the results of the judgmental sample are of special interest to TIGTA and likewise should interest practitioners.

In the latest audits, TIGTA found that the examiners generally documented the steps taken to plan the audits and used numerous fact-finding techniques to assess the accuracy of the returns. However, in 23% of S corporation audits and 37% of partnership audits, examiners did not fully consider issues between the S corporation or partnership and related returns (e.g., information returns, employment tax returns, or individual returns). Within these samples TIGTA also found a number of instances where one or more partners’ or shareholders’ estimated personal living expenses exceeded the income reported on the individual return by more than $10,000 (Rep’t No. 2012-30-060, p. 7; Rep’t No. 2012-30-062, p. 7). TIGTA felt this raised serious issues of whether the partnership or S corporation audits should have been expanded to include a search for additional sources of income that should have been included on the individual return.