Every year the IRS publishes audit statistics showing that it audits S Corporation returns much less frequently than it audits sole proprietorship (schedule C) returns. Consequently, one of the factors business owners and their advisors have traditionally considered before choosing a form of business is the relative likelihood of IRS scrutiny of the business’s tax return.
No surprises there, right?
Well, not so fast. Last week I attended a seminar on S Corporations in which the instructor made the following statement:
It’s a violation of Circular 230 for a tax advisor to advise his client to operate in the S Corporation form of business on the grounds that S Corporations are audited less frequently than sole proprietorships.
The statement roused me from my seminar slumber and prompted me to ask the following question:
Are you saying that I could be sanctioned by the Office of Professional Responsibility merely for telling my client the truth?
The instructor shrugged his shoulders and said “that’s the rule.”
Of course, as soon as I got back to the office I pulled up Circular 230 and searched for the odious provision. After several close readings, I couldn’t find it. Thinking that the instructor may have mistook his source, I looked up the AICPA Standards of Tax Services (PDF) and subjected them to the same close scrutiny. Still, I found nothing there that said or even implied that advising clients to incorporate as a means of reducing their chances of being audited is somehow unethical or against the rules.
I then broadened my search by googling the phrase “S corporation chances of audit” and found no less than fifty law firm and CPA websites that openly and unabashedly advise taxpayers to incorporate their businesses to reduce their chances of an IRS audit. And, as far as I could tell, the proprietors of these websites have not been sanctioned for rendering this advice.¹
If you know of an instance where a tax advisor has been reprimanded (or even investigated) for telling a client that S Corporation returns are less likely to be audited than sole proprietorship returns, please let me know. I would love to hear from you.
Note: The issue may soon prove moot as the IRS has announced that it will be auditing S Corporations more frequently in the future.
Footnotes:
¹ In a 2009 post titled Audit Avoidance a Tax Crime? I said this about tax pros advising their clients on how to minimize their chances of an IRS audit:
An IRS audit – or any government or regulatory authority audit for that matter – is disruptive, time-consuming and stressful and requires the disclosure of sensitive, private information. Consequently, there are good reasons other than the hiding of a criminal act to want to avoid an IRS audit and taxpayers should have every right to arrange their affairs in such a manner so as to do so.
16 responses so far ↓
1 Scott Bonacker CPA // Jun 15, 2010 at 10:22 am
There used to be a prohibition on discussing tax positions by describing them in terms of audit risk, but the last time I looked for it I couldn’t find it.
Perhaps that has something to do with the efforts to require disclosure of questionable tax positions on a tax return.
2 Chandler AZ CPA // Jun 15, 2010 at 10:22 am
Certainly S-Corps are audited less than Sch Cs. Last stats I saw said that Sch Cs were audited approx 2-3% while S-Corps were approx half of one percent. I wouldn’t think there would be any problems merely pointing out the stats to your clients.
3 LawStudent // Jun 15, 2010 at 11:12 am
I love your passion for the law you practice. Most lawyers, my dad included, go to these CLE courses just to fulfill the requirement and never give them a second thought.
You actually took the time to investigate what you were told and now are better informed and better able to help your clients. That is inspiring to me, however, I am a huge nerd who loves law school and cannot wait to get into practice.
I am a 2L and think that I want to practice law dealing with businesses (perhaps securities or contracts, which I loved) and taxation. Finding creative legal ways to reduce client’s tax liability is exciting to me. And, by the way, I intend to move to the Tampa area with my wife and take the Florida Bar after graduation. I would love to work for a firm that is as excited and passionate about law as I am and you seem to be.
4 LawStudent // Jun 15, 2010 at 11:12 am
By the way, my name is Steve.
5 Vincent Kan // Jun 15, 2010 at 11:46 am
I believe the instructor is referring to Circular 230 sections 10.35 and 10.37 that covers opinions and other written advice, both of which use the following language:
“Evaluation based on chances of success on the merits. In evaluating the significant Federal tax issues addressed in the opinion, the practitioner must not take into account the possibility that a tax return will not be audited, that an issue will not be raised on audit, or that an issue will be resolved through settlement if raised.”
To avoid the §6694 and §6662 tax preparer and taxpayer penalties, that means that you must meet your “substantial authority” standard without taking into account the audit lottery.
I think it is one thing to state the truth (the statistics with respect to Sch. C v. S Corp. audits) as opposed to advocating the S Corp. form because it is audited less often.
6 Peter // Jun 15, 2010 at 5:34 pm
Vincent,
Thanks for the cites.
Those sections do not prohibit a taxpayer or a tax preparer to consider the reduced likelihood of an IRS audit as one among many factors favoring the S Corporation form of business.
Nobody wants an audit, even (and maybe especially) the honest and compliant taxpayer.
7 Peter // Jun 15, 2010 at 5:36 pm
Chandler,
Thanks for your comment.
If the IRS doesn’t want taxpayers and their preparers to consider the likelihood of audit, it shouldn’t publish audit statistics showing that sole proprietorships get audited more often.
8 Peter // Jun 15, 2010 at 5:38 pm
Scott,
I think it’s malpractice for a tax advisor NOT to advise his clients that sole proprietorships receive substantially more IRS scrutiny.
9 Peter // Jun 15, 2010 at 5:39 pm
Steve,
Thanks for the kind comments. Don’t be so hard on your dad, though. These seminars are sometimes hard to endure.
10 Vincent Kan // Jun 15, 2010 at 6:44 pm
Actually I would argue that they do prohibit the advocacy of the S corp. form’s reduced audit risk if the position would not have “substantial authority” otherwise.
Taking “substantial authority” to mean about 40% likelihood of success on the merits, Cir. 230 §10.35 and 10.37 would prohibit advocating a position that has 39% LOSOTM ignoring the audit lottery and if taking into account your S corp statistics, over 99% chance of success with.
Once you’re over the “substantial authority” threshold, the taxpayer and preparer are out of the §6694 and §6662 penalty regimes at which point I could advocate the S corp. form as having less forward exposure to audit. I’d still be concerned though with the Economic Substance Doctrine codified in §7701(o) considering its application as a general anti-avoidance rule.
In short, I agree that there is no general rule against advocating tax positions that reduce audit exposure but that the position must otherwise be sound before it can be a factor to consider in giving advice.
11 Peter // Jun 15, 2010 at 6:50 pm
Vincent, its always legal to form an S corporation. And nobody, not even the IRS, can make you have a good reason for it.
12 Peter // Jun 15, 2010 at 6:50 pm
Vincent, also, there are at least a dozen othe reasons why choosing an S corporation is a sound decision to make.
13 LawStudent // Jun 15, 2010 at 7:51 pm
You’re right. My dad is a great lawyer and I admire him a great deal. Some of the CLE courses do sound ridiculous; I just appreciate your passion for law.
14 Vincent Kan // Jun 15, 2010 at 9:22 pm
I agree that given the right set of circumstances that the S corporation can and may very well be the best vehicle for achieving a set of goals. Given the advent of LLCs, the set of circumstances is much smaller than in years past but not zero. Until Congress writes S corporations out of the Code, we as advisors should be cognizant of the S corporation form and use it where it is the best solution consistent with our professional standards.
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