Small Businesses, Schedule UTP, and High-Wealth Audits

By Jonathan Prokup

Peter Pappas at the Tax Lawyer’s Blog takes note of a recent report from TIGTA regarding audits of small corporations (those with less than $10 million in assets, according to the IRS).  As Mr. Pappas says, language from the report suggests that Treasury may consider the closely held nature of many small businesses to be an indicator of a propensity to structure transactions to avoid taxes.

Many corporations in the United States are considered closely held because they are owned by one shareholder or a closely knit group of shareholders. As such, these shareholders typically have a significant amount of control over managing and directing the day-to-day operations of the corporation. This, in turn, provides opportunities to improperly structure transactions that reduce the amount of income taxes owed by the small corporation or its shareholders.

In effect, the report identifies a principle that the government has long applied to large companies as well: transactions among related parties that do not involve third parties deserve particularly close scrutiny.  This principal is applied to taxpayers of all sizes in a variety of contexts, including transfer pricing and the economic substance doctrine.  More relevant to Mr. Pappas’ primary point, though, this statement tends to confirm a trend within the Treasury Department towards targeting small and medium-sized businesses and their owners for examination.

Recall that, starting in 2012, the threshold of assets above which corporations will be required to file a Schedule UTP drops to $50 million; and in 2014, that threshold drops to $10 million.  Also, as mentioned in Announcement 2010-75, the IRS is considering whether to extend the Schedule UTP filing requirements to other taxpayers, such as pass-through entities (e.g. partnerships and S corporations) and tax-exempt entities.  In this regard, it bears noting that in the IRS’ most recent estimate of the “tax gap,” underreporting of business income by individuals (i.e., through sole proprietorships, partnerships, and S corporations) was, by far, the largest source of underreporting of income for U.S. tax purposes.  (The “tax gap” refers to the difference between the amount of tax that taxpayers should pay and the amount that is paid timely and voluntarily.)

Further, in 2009, the IRS formed the Global High Wealth Industry Group, a unit that conducts audits of individuals who have assets or income in the tens of millions of dollars and who may have related offshore entities in which the IRS suspects income may be hidden.  Some practitioners have taken to scaring prospective clients with the specter of being audited by this group (a risk not to be taken lightly, to be sure).

Nevertheless, as the Transactional Records Access Clearinghouse (TRAC) at Syracuse University has pointed out, the High Wealth unit conducted only 11 audits during the first six months of the 2011 fiscal year.  And, according to TRAC, the IRS’ 12-month audit target of these taxpayers for all of FY 2011 included only 122 returns.  For reference, the IRS received 8,274 returns in 2009 (most recent data available) reporting adjusted gross income of $10 million or more.  At the rate of 122 returns per year, it would take the High Wealth unit more than 67 years to examine each of those returns just once.  (Admittedly, those returns could still be subject to other, more cursory audits by the IRS.)

In sum, the Treasury Department as a whole has been taking steps to increase enforcement among small- and medium-businesses and their owners.  Nevertheless, it remains unclear whether the IRS, charged with executing that increased enforcement, has sufficient resources to achieve that goal.

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