Small businesses face unwelcome IRS scrutiny

The IRS plan to audit S corporations for possible tax abuses comes at an awkward time for the popular businesses as they continue to step up their push for a bill to ease their regulatory burdens.

S corporation is the nation’s most common corporate tax designation, used by more than 3 million small-business owners who take advantage of the accompanying tax breaks to stimulate their profits. Numerous conglomerates began life as S corporations, including Kinko’s and NASCAR.

The random IRS screening of S-corporation tax returns, in concert with two government proposals this year to start levying payroll taxes on the businesses, has become unwelcome attention as lawmakers work on drafting broad S-corporation legislation.

“It’s politically risky, sure, for the IRS. If they want to go down this road … we don’t want [our businesses] to be stifled based on scare tactics,” said Ryan Peebles, manager of legislative affairs at the National Federation of Independent Business (NFIB).

Sen. Blanche Lincoln (D-Ark.) and Rep. Clay Shaw (R-Fla.) are both sponsors of the most current S-corporation bill, which would make it easier for so-called C corporations (which include most publicly traded firms) to convert to S status. Lincoln and Shaw are planning to introduce a new S-corporation bill soon after the August recess that would address myriad small-business priorities, and lobbyists said the growing public notice of S corporations could turn out to be less of a setback once the bill comes out.

Heidi Blumenthal, a tax lobbyist for the Associated General Contractors (AGC), said that the IRS audit and the payroll-tax debate are “creating focus” on S corporations and that even negative focus is a boon for lobbyists working on such a complex issue. “It’s … a jumping-off point for the [Lincoln-Shaw] modernization bill, that has actually been worked on for quite a while. But now people are more ready to talk about it.”

Congress will increase the IRS enforcement budget for next year by as much as 8 percent, empowering the agency to close the $300-billion-plus gap between tax bills and taxes paid in the United States. Cracking down on S corporations, which are prone to tax evasion and sheltering by business owners, could be a huge revenue generator at a time when the growing federal deficit cries out for new money to be generated by busting delinquent taxpayers.

“The use of S corporations has exploded. The IRS needs a better understanding of what this means for tax compliance,” IRS Commissioner Mark Everson said in a statement following the agency’s audit announcement.

Hitting S corporations with Social Security and Medicare payroll taxes also would pad government coffers by $57 billion, as suggested in a January report from the congressional Joint Committee on Taxation and May testimony from J. Russell George, an inspector general at the Treasury Department. Both the report and the testimony alarmed business trade organizations and, despite the negative tone, mobilized S-corporation lobbyists to play good defense.

“You’re starting to get [congressional] staff talking about it, looking at it. That makes it a lot easier for us, in terms of lobbying on the education side,” Blumenthal said. The AGC, the NFIB and the U.S. Chamber of Commerce joined more than 20 other groups in petitioning congressional leadership to condemn publicly the payroll-tax proposal.

Brian Reardon, the top lobbyist at the S Corporation Association, said his goal was to keep the larger legislative changes sought by S corporations separate from the communications challenges posed by the payroll-tax and audit developments.

“It’s two different tracks,” Reardon said. “The modernization effort has its own momentum. The payroll-tax issue is an effort to educate members as to why the proposals on the table are bad policy and going to hurt business creation.”

S-corporation shareholders are currently exempt from payroll taxes because their income from the businesses is not classified as traditional earnings. Only passive income of S-corporation members is taxed, at a rate of 25 percent relative to total income; the coming Lincoln-Shaw bill likely will heed a Joint Committee on Taxation recommendation and hike that number to 60 percent.

Other priorities for S-corporation owners include allowing tax deductions for stock donated to a charitable organization and lifting the ban on nonresident aliens’ serving as shareholders. An S corporation can have no more than 100 shareholders, and strict curbs are in place to prevent individual retirement accounts from buying S-corporation stock.

Peebles said that the NFIB’s S-corporation owners average only five employees and no shareholders and that the “lack of manpower to help out” makes the burden of a random IRS audit “a tremendously frightening experience” for small-business owners.