The Government Accountability Office (GAO) issued a December 2009 report to the Senate Finance Committee on the "Tax Gap: Actions Needed to Address Noncompliance with S Corporation Tax Rules."
Many Americans doubtless don't know an S Corporation from a German silent partnership, except for the attention the S Corp got when John Edwards was running for President and word got out that he managed some considerable tax savings through his S Corp. So, herewith a small primer.
S corporations are ordinary "C corporations" that have made an election that permits qualifying corporations to avoid the corporate level tax and pass through the tax items (income, deductions, etc.) to the S corporation shareholders. S corporations cannot have multiple classes of stock and can only have certain types of shareholders, so that they are somewhat less flexible than taxable C corporations. Most S corporations have just 1-3 shareholders. (Of course, some of the tax changes made during the Bush years made the S corporation more widely available, and in particular facilitated certain banks' use of the form.) S corporations have been increasing in popularity, because of the combination of limited liability protection and pass-through of tax items that avoids an entity level tax.
According to the report, a large majority of S corp returns (68% for 2003-2004, the last years for which the reporters had data) misreport at least one item and tend to misreport to the favor of the S corporation/shareholder 80% of the time. The returns misreport net income, basis, distributions, and gross sales. Many treat shareholders' personal expenses as deductible in calcuating the net income reportable. Many don't substantiate the expenses that are taken as a deduction. A common error is for a shareholder to use losses that should be disallowed because the shareholder doesn't have enough basis to take the loss. Another common problem is underreporting of shareholder compensation, which, unlike distributions, is subject to payroll taxes. (/this was the issue raised about John Edwards' S corporation.). The fewer shareholders the S corporation has, the more likely it is to have errors on the return. And of course, paid preparers tend to add to problems (71% use paid preparers).
The recommendations include improving return preparer compliance, which the IRS already has started working on, and changing the statute to require basis calculation at the entity level. The report also note that the vagueness about what constitutes reasonable wage compensation is a problem that could be addressed in the Code or regulations, and lack of IRS nenforcement in this area is a problem. The report discusses some legislative options (such as making net business income subject to emplyment taxes) and some administrative options (such as improving guidance for examiners and better educating taxpayers).
By the way, these S Corporation shareholders are mostly comprised of the "small businessmen" that the right-wing anti-tax crowd constantly claims is overtaxed. Hmmmm. Looks like the bigger issue with this group is noncompliance, not overtaxation. We need to increase enforcement efforts, especially focused on the particular items that have tended to be misreported in S corporation returns.