In light of TIGTA’s report and recommendations, the IRS is updating the Discriminate Index Function (DIF), used to score corporate tax returns for their audit potential. The DIF assigns a higher score to corporate returns containing red flags such as larger-than-usual deductions, losses, and expenses, blank sections, and too many round numbers. The higher the score, the more likely a corporate return will trigger an audit.
The high “no-change” rate may be due in part to outdated DIF formulas, last updated in 1988. The report stated the following:
“Consequently, it is no surprise that the passage of time has made using the DIF less useful for identifying and searching returns for audit, given the tax law and economic changes that have occurred.”
In light of the age of the DIF formulas, the current policy is for the IRS to use non-DIF sources to select appropriate corporate returns for audit. This is one factor that TIGTA attributes to the increasing amount of recommended additional taxes. For FY 2010, 45 percent of the corporate audits involved returns selected by non-DIF sources.
The IRS plans to conduct a National Research Program study of tax compliance by small corporations and small corporate shareholders. The study could lead to an updated DIF that the IRS would use to generate a new workload identification formula for taxpayers with similar situations as those selected for the study. Officials anticipate that the study will involve the selection of 2,500 returns from the 2010 tax year filed by corporations with assets of less than $250,000.
In light of the likely increase in number or intensiveness of IRS small corporate audits, TIGTA recommended that practitioners should alert their corporate clients to several IRS programs and initiatives designed to improve small business tax compliance.
Voluntary Classification Settlement Program (VCSP). Under the VCSP, qualifying employers can reclassify their workers as employees rather than improperly classified independent contractors, for whom they pay no employment taxes. In exchange for their voluntary compliance with the tax laws, they will pay an amount of just over one percent of the wages paid to the reclassified workers for the past year, but without interest or penalties. Additionally, the employers will not be audited on the reclassified workers’ payroll taxes for prior years.
To qualify, employers must have consistently treated the workers to be reclassified as nonemployees and filed all required returns, such as Form 1099, for at least the three prior calendar years. In addition, employers may not currently be under audit for worker classification issues by the IRS, U.S. Department of Labor, or any state government agency.
IRS outreach efforts. Acknowledging that SB/SE compliance issues arise out of taxpayer ignorance of the ever-changing Tax Code, the IRS has focused on increasing its customer service, website navigation, and available educational materials.
Because the majority of SB/SE division tax returns are prepared by practitioners, much of the outreach effort is intended for practitioners. But telephone assistance is available for businesses during the work week, from Monday through Friday, 7:00 am to 10:00 pm EST. There is a 24-hour recorded assistance line as well.
“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 so they reduce the income taxes owed by the corporation or the shareholders.”