Pass-through Filers Take Heed: Understanding the Latest Audit Risks for Small Businesses and How to Understand the Details

In today’s business world, there has been an increasing number of closely held small business employers, such as C corporations, S Corporations, partnerships and sole proprietorships. Many of which are pass-through entities that are businesses that don’t pay income taxes directly. Instead, their income is passed through to their owners who pay taxes on it on their individual returns under schedule C. These closely held small businesses have assets of 10 million dollars or less. Both small and large pass-through businesses have become the economic powerhouse in the United States because they earn more net business income than C corporations (although C corporations surpass pass-throughs in gross receipts), employ over half the workforce in the United States, and are often taxed at top individual tax rates. An Internal Revenue Service (IRS) study reveals the organization’s interest and increasing focus on pass-through businesses, in terms of both its structure and priorities, have tripled in size since 1980 (Pomerleau 2015). From the approximate 92,000 IRS employees, about 47,000 of them work in the small business/self-employed unit, one of four operating units in the IRS (Treasury Inspector General for Tax Administration 2014). However, the IRS currently audits schedule C filers 18.5 times more than partnerships or S Corporations. Therefore, pass-through filers are much more susceptible to being audited which makes it even more important to understand processes and the triggers for being audited as well as what the IRS has in store for the future. In addition, you audit chance increase the better you are doing. This paper examines these new rules and offers guidance to help preparers avoid pitfalls.