From another CPA:

Subject: Small Business Audit Risk

Here is some interesting data for IRS examination coverage based on returns filed in 2004:

 

Type of Return                                  % covered

Sch C(gross receipts under 25K)           3.68

Sch C(25 to 100K)                                2.21

Sch C(over 100K)                                 3.65

Small Corp(assets under 10M)               0.79

1065                                                    0.33

1120S                                                  0.30

 

It appears that the overall audit risk is much greater for Self-employed versus partnership or corporation filings.  However the data is broken down further.  It turns out that Sch C with gross receipts of less than 100K have only about a 0.5% chance of examination by a Revenue Officer or Tax Compliance Officer.  The balance being Compliance Center inquiries which usually ask for clarification, more data, etc.  In the rest of the filing categories, most of the exams are Revenue or Tax Compliance Officer, meaning a face to face visit.

 

I wonder if the cause of the differences could be that many, many Sch C are completed by the taxpayer whereas most entity returns are prepared by a tax professional.  We will probably never know the real reason as the IRS avidly protects its selection criteria.

My Reply:

While that is a plausible theory to explain the disparity in audit coverage, I had a slightly different one when I saw those stats a few months back.

I think it has a lot to do with the looser internal controls with most small Sch. C businesses than is normal with more formally established business entities, allowing for much greater opportunity for the owners to put money in their pockets. This difference is especially true when there are multiple owners of the business, such as with a partnership. One of the most basic internal controls is the division of duties and the inability of one person to handle all of the money without anyone else checking on him/her.  While it obviously possible for multiple owners to collude to cheat on the business's taxes, it is much less likely to happen than with a single person operation who has nobody looking over his/her shoulders.

It has also long been known that IRS has had their sights set on businesses that operate mainly with cold hard cash because of the skimming opportunities available and no bank account paper trail for IRS to work with.  While I don't have any stats on these particular businesses in terms of entity, I'm guessing that more of them are Sch. C because of the lack of formal business requirements.  Somebody who would want to cheat on their taxes by under-reporting income would most likely opt for the lowest profile business structure, which we all know is a Sch. C.

That's just my theory.

Thanks for writing and sharing yours.

Kerry Kerstetter

Follow-Up:

Yes, internal controls are certainly a problem and I am sure that the IRS recognizes that.  I have also found that problem in family businesses that are organized as partnerships or S corps.  They usually start off paying attention to the details of cash moving through the company but then get sloppy and cash ends up going to non-business purposes.  Most do it from ignorance and I encourage/help them fix it.  I've had a few that feel that actual cash is not income and have had to drop them as clients.

 

Thanks for the response. 

 

 

- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 6/01/2006 11:00:00 AM Send this post: