The Treasury Inspector General for Tax Administration (TIGTA) recently released two reports for its study of the IRS Small Business/Self-Employed (SB/SE) Division’s audits of partnerships and S corporations. The findings in both reports are similar: Although the SB/SE audits recommended substantial adjustments, roughly 33% of all the audits in fiscal years 2009–2011 resulted in no change. While this may not surprise many practitioners, the TIGTA reports do offer 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 is the discriminant index function (DIF) system, which the IRS has relied on for years. It uses mathematical formulas to score returns based on their audit potential. 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, only 19% of S corporations 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%.
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; for each partnership audited in FY 2011, recommended adjustments averaged $137,000. Interestingly, due to systems limitations, neither the IRS nor TIGTA knows for certain how much additional tax was assessed based on the examiners’ recommendations.
How to Improve Audit Productivity
TIGTA found that improvements to the DIF system are not likely in the near future and 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. 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.
For a detailed discussion of the issues in this area, see “The Number of No-Change Audits Is a Concern,” by Mark A. VanDeveer, CPA, in the January 2013 issue of The Tax Adviser.
—Alistair M. Nevius, editor-in-chief
The Tax Adviser
Also look for articles on the following topics in the January 2013 issue of The Tax Adviser:
- An examination of the new tangible property regulations.
- A discussion of reporting trust and estate distributions to foreign beneficiaries.
- A look at judicial deference to Treasury regulations after Home Concrete.
The Tax Adviser is the AICPA’s monthly journal of tax planning, trends, and techniques. AICPA members can subscribe to The Tax Adviser for a discounted price of $85 per year. Tax Section members can subscribe for a discounted price of $30 per year. Call 800-513-3037 or email email@example.com for a subscription to the magazine or to become a member of the Tax Section.