GAO 

United States Government Accountability Office

Report to the Committee on Finance, 

U.S. Senate 

TAX GAP

Actions Needed to 

Address 

Noncompliance with 

S Corporation Tax 

Rules 

December 2009 

GAO-10-195 
What GAO Found

United States Government Accountability Office

Why GAO Did This Study

Highlights

Accountability Integrity Reliability

December 2009

TAX GAP

Actions Needed to Address Noncompliance with 

S Corporation Tax Rules

Highlights of GAO-10-195, a report to the 

Committee on Finance, U.S. Senate 

S corporations are one of the 

fastest growing business types, 

accounting for nearly 4 million 

businesses in 2006. However, longstanding problems with S 

corporation compliance produce 

revenue losses in individual income 

taxes and employment taxes. GAO 

was asked to (1) describe the 

reasons businesses choose to 

become S corporations, (2) analyze 

types of S corporation 

noncompliance, what IRS has done 

to address noncompliance, and 

options to improve compliance, 

and (3) further analyze the extent 

of shareholder compensation 

noncompliance and identify 

options for improving compliance. 

GAO analyzed IRS research and 

examination data; interviewed IRS 

officials, examiners and other 

knowledgeable stakeholders; and 

reviewed relevant literature. 

What GAO Recommends

Congress should require S 

corporations to calculate and 

report basis for their shareholders’ 

ownership shares. 

GAO also recommends that IRS 

research options for improving the 

performance of professional tax 

preparers, provide additional 

guidance to new S corporations on 

calculating basis and 

compensation, require examiners 

to document analysis of 

compensation, and provide more 

guidance on compensation. 

In commenting on a draft of this 

report, IRS generally agreed with 

our recommendations. 

An S corporation is a federal business type that provides certain tax and other 

benefits, including a single level of taxation, limited employment taxes, and 

the ability to pass through business losses to shareholder returns. Single-level 

taxation can reduce overall taxes assessed based on business income, and 

applying business losses to individual returns can decrease shareholder tax 

obligations. S corporations also benefit from limited liability protection. 

According to IRS data, about 68 percent of S corporation returns filed for tax 

years 2003 and 2004 (the years data were available) misreported at least one 

item. About 80 percent of the time, misreporting provided a tax advantage to 

the corporation and/or shareholder. The most frequent errors involved 

deducting ineligible expenses, which could decrease S corporation 

shareholder tax liabilities. Even though a majority of S corporations used paid 

preparers, 71 percent of those that did were noncompliant. Stakeholder 

representatives said that preparer mistakes may be due to the lack of preparer 

standards as well as their misunderstanding of the tax rules. Shareholders of S 

corporations also made mistakes in calculating basis – their ownership share 

of the corporation – when taking losses passed to them from the corporation, 

potentially decreasing their total taxes. IRS officials as well as stakeholder 

representatives said that calculating and tracking basis was one of the biggest 

challenges for shareholders, and that S corporations themselves were in a 

better position in most cases to calculate basis for their shareholders. 

Some S corporations also failed to pay adequate wages to shareholders for 

their labor for the corporation, which led to underpaying employment taxes. 

Joint Committee on Taxation (JCT) and Treasury Inspector General for Tax 

Administration (TIGTA) reports show that inadequate shareholder wage 

compensation is a significant issue. Using IRS data, GAO calculated that in the 

2003 and 2004 tax years, the net shareholder compensation underreporting 

equaled roughly $23.6 billion, which could result in billions in annual 

employment tax underpayments. Stakeholder representatives, IRS officials, 

and TIGTA have indicated that determining adequate shareholder 

compensation is highly subjective and hinders compliance and enforcement. 

IRS provides limited guidance on determining adequate compensation. 

Stakeholder representatives indicated that specific IRS guidance for both new 

and existing S corporations could help improve compliance. Additionally, IRS 

examiners often were not taking advantage of certain techniques in examining 

shareholder compensation. Analyzing a random sample of IRS examinations, 

GAO found that in cases where IRS examiners did document a form of 

analysis, they were more likely to make an adjustment than when no evidence 

of such analysis existed. Currently, IRS does not require specific 

documentation of their analysis for shareholder compensation by examiners. 

Legislative options exist to improve compliance with shareholder 

compensation rules; however, these options also raise notable trade-offs. View GAO-10-195 or key components.

For more information, contact Mike Brostek at 

(202) 512-9110 or brostekm@gao.gov. 
Page i GAO-10-195 Noncompliance with S Corporation Tax Rules 

Contents 

Letter 1

Background 3 

S Corporations Provide Certain Tax-Related and Other Advantages 6 

In Tax Years 2003 and 2004, a Majority of S Corporations Were 

Noncompliant with at Least One Tax Rule; Various Options Exist 

to Address Noncompliance 10 

Inadequate Wage Compensation to S Corporation Shareholders 

Creates Employment Tax Noncompliance, Which Could be 

Addressed through Legislative or Administrative Changes 24 

Conclusions 36 

Matter for Congressional Consideration 36 

Recommendations 37 

Agency Comments 37 

Appendix I Scope and Methodology 39 

Appendix II Trends in the Growth of S Corporations 43 

Appendix III Analysis of S Corporation Losses 46 

Appendix IV Comments from the Internal Revenue Service 51 

Appendix V GAO Contact and Staff Acknowledgments 53 

Tables 

Table 1: Important Tax Considerations by Business Entity Type 7 

Table 2: Most Common Misreported Line Items by Number of S 

Corporations Misreporting and Amounts Misreported 

(Absolute Dollar Values), Tax Years 2003 and 2004 

Combined 11 

Table 3: Percentage of S Corporations Underreporting and 

Overreporting Common Line Items, Tax Years 2003 and 

2004 Combined 12 
Table 4: Percentage of S Corporations Misreporting Common Line 

Items by Number of Shareholders, Tax Years 2003 and 

2004 Combined 13 

Table 5: Type of Misreporting by S Corporations, Tax Years 2003 

and 2004 Combined 14 

Table 6: Options for Improving Compliance with S Corporation 

Rules 19 

Table 7: Estimated Number of S Corporation Examinations with 

Shareholder Compensation Issues, Examinations Closed in 

Fiscal Years 2006 to 2008 28 

Table 8: Legislative Options to Address Shareholder Compensation 30 

Table 9: Identified Pros and Cons of Basing Employment Tax 

Liability For Shareholders on the Net Business Income 

Reported by S Corporations 30 

Table 10: Identified Pros and Cons of Basing Employment Tax 

Liability on All Types of Payments Made to Active 

Shareholders 33 

Table 11: S Corporations Taking Ordinary Losses in Multiple Years, 

Tax Years 2001 to 2006 46 

Table 12: S Corporations Taking Ordinary Losses in Consecutive 

Years, Tax Years 2001 to 2006 47 

Table 13: S Corporation Ordinary Losses, Tax Years 2001 to 2006, 

for S Corporations that Took Losses in 2003 47 

Table 14: Total and Median Ordinary Losses Claimed by S 

Corporation Shareholders, Tax Year 2001 49 

Table 15: Percentage of Non-S-Corporation Income Offset by S 

Corporation Losses, Tax Year 2001 50 

Figures 

Figure 1: Total S Corporation Assets, Net Income, Gross Business 

Receipts, and Deductions, Tax Years 2000 to 2006 4 

Figure 2: Net Value of Adjustments for Shareholder Compensation 

in Billions, by Number of Shareholders, Tax Years 2003 

and 2004 26 

Figure 3: Number of Businesses by Business Type, Tax Years 2000 

to 2006 43 

Figure 4: Share of Total Net Income, Business Receipts, 

Deductions, and Assets by Number of Shareholders, Tax 

Year 2006 44 

Figure 5: Newly Elected S Corporations, Tax Years 2000 to 2006 45 

Page ii GAO-10-195 Noncompliance with S Corporation Tax Rules 
Figure 6: S Corporation Loss Taking By Number of Shareholders, 

Tax Year 2006 48 

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Page iii GAO-10-195 Noncompliance with S Corporation Tax Rules 
Page 1 GAO-10-195 Noncompliance with S Corporation Tax Rules 

 

United States Government Accountability Office

Washington, DC 20548 

 

December 15, 2009 

The Honorable Max Baucus 

Chairman 

The Honorable Charles Grassley 

Ranking Member 

Committee on Finance 

United States Senate 

S corporations have been one of the fastest growing business entity types 

in recent years, displaying the second largest percentage increase among 

federal business types from tax year 2000 to 2006, next to partnerships.1

 In 

2006, nearly 4 million S corporations accounted for $3.3 trillion in total 

assets as well as $413 billion in total net income.2

 The S corporation entity 

type provides limited liability protection3

 to shareholders,4 and S 

corporations “pass through” gains and losses to shareholders’ individual 

tax returns without generally paying taxes at the entity level. 

In addition, if S corporations are not compliant with tax requirements, 

income, losses, and deductions passed through to the shareholders will be 

inaccurate, resulting in noncompliance on their individual income taxes. 

The Internal Revenue Service (IRS) does not have an estimate of tax losses 

due to S corporation noncompliance. IRS has estimated that income tax 

revenue losses due to pass-through entities’ noncompliance, including S 

corporations, totaled $22 billion for tax year 2001, which is IRS’s most 

recent estimate. In addition, employment tax revenue losses due to 

noncompliance with tax rules were estimated to be $15 billion for all types 

of entities (including S corporations) in 2001. For example, S corporations 

must pay employment taxes on wage compensation paid to officers and 

1

This report does not address entities created under state law, such as limited liability 

companies (LLCs), which may elect to be taxed as S corporations or any of the three other 

federal business types. Most new partnerships are LLCs. 

2

These figures are based on IRS’s Statistics of Income (SOI) data. All SOI dollar figures in 

this report are converted into 2009 dollars. 

3

Limited liability protection means that a shareholder’s financial liability for a company is 

limited to the amount of their investment in the company. Generally, the shareholder’s 

other personal assets cannot be affected by the company’s debts or by any lawsuits. 

4

Owners of S corporations are referred to as shareholders. The percentage of stock 

(shares) owned by a given shareholder determines his or her ownership stake. 
employees. S corporations may be tempted to pay shareholder-employees 

an inadequate wage and higher distribution5

 to avoid employment tax 

liabilities. 

Due to the growth in S corporations and concerns about its tax losses, you 

asked us to examine noncompliance with S corporation tax rules. This 

report (1) describes reasons a business might choose to become an S 

corporation; (2) analyzes types of S corporation noncompliance, what the 

IRS has done to address noncompliance overall, and options to improve 

compliance; and (3) further analyzes the extent of noncompliance 

involving a long standing concern over inadequate shareholder 

compensation, and identifies options for improving compliance. 

To describe reasons for a business to choose S corporation status, we 

reviewed relevant literature and interviewed IRS officials. We interviewed 

over 40 stakeholder representatives of nine industry and professional 

organizations, including small business associations, tax preparer groups, 

and legal professionals. Using the information gathered from these 

sources, we determined tax and nontax considerations that might motivate 

business owners to elect S corporation status over the other business 

entity types. To analyze types of S corporation noncompliance, we used 

data from S Corporation National Research Program (NRP) samples 

drawn for tax years 2003 as well as for 2004.6

 We also reviewed a random, 

nongeneralizable sample of 166 cases from the 2003 and 2004 S 

Corporation NRP for insights on the noncompliance. To determine what 

IRS has done to address noncompliance and options for improvement, we 

analyzed IRS examination data from its Examination Operational 

Automated Database (EOAD) for fiscal years 2006 to 2008. In addition, we 

interviewed IRS officials, including groups of IRS examiners, and the 

industry representatives mentioned above, and collected information from 

IRS on its enforcement and service programs. To further analyze the 

extent of noncompliance in reporting shareholder compensation, we used 

data from the S Corporation NRP. To determine options for improving 

compliance on shareholder compensation, we reviewed relevant studies 

 

5

A distribution is any payment of S corporation funds to a shareholder, including personal 

expenses paid by the corporation. A distribution does not include wage payments or 

repayment of loans. 

6

The NRP studied reporting compliance for a random sample of tax returns filed for tax 

years 2003 and 2004. IRS examined about 4,800 of these returns to determine whether S 

corporations accurately reported the income, expenses, and other items. 

Page 2 GAO-10-195 Noncompliance with S Corporation Tax Rules 
and articles and interviewed the IRS officials and stakeholder 

representatives mentioned above. All percentage estimates in this report 

have 95 percent confidence intervals that are within +/- 8 percentage 

points of the estimate itself, unless otherwise specified. All other estimates 

in this have 95 percent confidence intervals that are within +/- 10 percent 

value of the estimate itself, unless otherwise specified. We determined for 

the purposes of this review that the data used were reliable. When 

possible, we compared published results with self-generated analyses. 

(See app. I for further discussion of our scope and methodology.) We 

conducted this performance audit from May 2007 to October 2009 in 

accordance with generally accepted government auditing standards. Those 

standards require that we plan and perform the audit to obtain sufficient, 

appropriate evidence to provide a reasonable basis for our findings and 

conclusions based on our audit objectives. We believe that the evidence 

obtained provides a reasonable basis for our findings and conclusions 

based on our audit objectives. 

S corporations are a common and growing business type. For federal tax 

purposes, businesses generally operate as S corporations, C corporations, 

partnerships, or sole proprietorships. According to the most recent IRS 

data available, the number of S corporations grew by 35 percent from tax 

year 2000 to 2006, for a total of nearly 4 million businesses in 2006. S 

corporations have also grown as a proportion of all businesses, from 11.4 

percent of all entities in tax year 2000 to 12.6 percent in tax year 2006. In 

2006, they were the second most common entity type after sole 

proprietorships. 

Background 

S corporations’ assets and total net income also demonstrate their 

economic significance. From tax years 2000 to 2006, S corporations’ total 

net income7

 grew by 67 percent, or $166 billion, and their total assets grew 

by 46 percent, or $1.0 trillion.8

 Gross business receipts and deductions also 

increased substantially in this time period. Figure 1 shows total S 

corporation assets, net income, gross business receipts, and deductions in 

tax years 2000 to 2006. 

 

7

This report uses the “net income (less deficit)” variable for all net income figures, unless 

otherwise stated. 

8

Adjusted to 2009 dollars. For comparison’s sake, net income for all businesses grew by 62 

percent and total assets grew by 44 percent over the 2000 to 2006 period. 

Page 3 GAO-10-195 Noncompliance with S Corporation Tax Rules 
Figure 1: Total S Corporation Assets, Net Income, Gross Business Receipts, and Deductions, Tax Years 2000 to 2006 

0

1

2

3

4

5

6

7

2000 2001 2002 2003 2004 2005 2006

Trillions of dollars

Tax year

Source: GAO analysis of IRS’s SOI data.

Assets

Net income 

Gross business receipts

Deductions

Most S corporations are held by three or fewer shareholders. In tax year 

2006, 60 percent of S corporations had a single shareholder, 89 percent 

had two or fewer shareholders, and 94 percent had three or fewer 

shareholders. S corporations held by three or fewer shareholders 

accounted for the majority of the net income, gross receipts, deductions, 

and assets for S corporations in 2006, and those held by a single 

shareholder accounted for over 30 percent of these items. 

Conversions of C corporations to S corporations have contributed to the 

growth in numbers of S corporations; between 78,000 to 97,000 

C corporations converted to S corporations per year from tax years 2000 

to 2006, 9 representing 23 to 31 percent of new S corporations each year.10

 

9

 Estimates for conversions are within +/-14 percent of the reported values. 

Page 4 GAO-10-195 Noncompliance with S Corporation Tax Rules 
Appendix II provides additional details on trends in the growth, size, and 

characteristics of S corporations. 

Reporting Rules S corporations are small business corporations that file an election form 

(Form 2553, Election by a Small Business Corporation) that allows them 

to be taxed under subchapter S of the income tax section of the Internal 

Revenue Code. They must meet the following requirements to be 

recognized as an S corporation: 

• be a domestic corporation; 

• have only eligible shareholders, which include individuals, estates, certain 

trusts, and certain tax-exempt organizations, but not partnerships, 

corporations, or nonresident aliens; 

• have no more than 100 shareholders (multiple members of a family may 

count as a single shareholder for this purpose); and 

• have only one class of stock.11

S corporations file Form 1120S (U.S. Income Tax Return for an S 

Corporation) to report their business income, losses, and other items 

related to federal tax laws. S corporations are also required to provide 

their shareholders and IRS with a Schedule K-1 (Shareholder’s Share of 

Income, Deductions, Credits, Etc.) to report information on the allocation 

of income, losses, and other items. Using the K-1 information, 

shareholders of S corporations report their pass-through ordinary income 

or losses on Part II of Schedule E (Supplemental Income and Loss), which 

most shareholders are to attach to the individual income tax return, Form 

1040.12 Other separately stated items of income, loss, or deductions are 

reported on various other Form 1040 schedules. For example, interest 

income is reported on the shareholder’s Form 1040, Schedule B and a 

capital gain or loss is reported on the shareholder’s Form 1040, Schedule 

D. 

Basis A shareholder can claim S corporation losses and deductions to offset 

other income earned by the individual shareholder. However, the 

shareholders generally can only claim losses and deductions up to the 

 

10IRS does not have data on conversions from S corporation to C corporation status, but 

testimonial evidence indicates that this happens infrequently. 

1126 U.S.C. § 1361(b). 

12S corporation shareholders that are not individuals (e.g., trusts and estates) fill out Form 

1040 Schedule E, and are to attach it to their respective tax forms (e.g., Form 1041). 

Page 5 GAO-10-195 Noncompliance with S Corporation Tax Rules 
amount of basis the shareholder has in the S corporation’s stock and 

debt.13 Stock basis begins with the shareholder’s initial capital contribution 

to the S corporation or the initial cost of the stock purchased. That 

amount may increase or decrease each year. An income item will increase 

stock basis; a loss, deduction or non-dividend distribution will decrease 

stock basis, based on certain ordering rules. For losses and deductions 

that exceed a shareholder’s stock basis, the shareholder is allowed to 

deduct the excess up to the shareholder’s debt basis, which is created by 

loans that the shareholder personally made to the S corporation. 

Employment Tax Like any employer, S corporations must pay and withhold for employment 

taxes on wages.14 Unlike partnerships and sole proprietorships, S 

corporations can pay both wages and distributions to shareholders, but 

only wages are subject to employment taxes. IRS requires that S 

corporations pay a reasonable compensation (or wage) to shareholders 

who perform services for the S corporation.15

A single level of taxation, the ability to pass through business losses to 

shareholders, and calculating employment taxes on wages rather than net 

business income are the most significant tax-related reasons that business 

owners elect treatment as an S corporation. While S corporations share 

each of these characteristics with other business types, it is the only 

business type with all three of these characteristics, as shown in table 1. 

S Corporations 

Provide Certain TaxRelated and Other 

Advantages 

 

13Shareholder claims of losses are also subject to at-risk limitations – they may only claim 

losses for which they were financially liable – and passive activity rules, which limit 

claiming losses on business activities in which the shareholder did not materially 

participate. 

14Employers are required to withhold for individuals’ federal income taxes and Federal 

Insurance Contribution Act (FICA) taxes, which includes Social Security and Hospital 

Insurance (Medicare Part A) taxes on employees’ wages. They are also required to match 

the amounts withheld for an employee’s Social Security and Medicare taxes, and to pay 

Federal Unemployment Tax Act (FUTA) taxes on wages paid to employees. Employees’ 

federal income tax withholding, FICA, and FUTA taxes are referred to as employment 

taxes. The tax rate for Social Security is 12.4 percent of total wages and tips (as well as net 

earnings for sole proprietorships and partnerships) up to a cap, which was $106,800 for 

2009. The tax rate for Medicare is 2.9 percent, with no cap. Federal unemployment tax was 

6.2 percent in 2009 on the first $7,000 in earnings. Federal income tax withholding rates 

vary. 

15See Rev. Rul. 74-44, 1974-1 C.B. 287. 

Page 6 GAO-10-195 Noncompliance with S Corporation Tax Rules 
Table 1: Important Tax Considerations by Business Entity Type 

S corporation C corporation Partnership Sole proprietorship 

Levels of taxation Business income is 

taxed at the individual 

tax rate (single level) 

Business income is taxed at 

the corporate tax rate and, if 

distributed, at the individual 

dividend tax rate (double 

taxation) 

Business income is 

taxed at the individual 

tax rate (single level) 

Business income is taxed 

at the individual tax rate 

(single level) 

Treatment of 

business lossesa

Business losses pass 

through to the individual 

income tax return and 

can offset other income 

Business losses do not pass 

through, but can offset 

business income on the 

corporate return 

Business losses pass 

through to the individual 

income tax return and 

can offset other income 

Business losses pass 

through to the individual 

income tax return and 

can offset other income 

Employment taxes Employment taxes are 

assessed on wages 

Employment taxes are 

assessed on wages 

All net income of 

general partners is 

subject to selfemployment tax 

All net income is subject 

to self-employment tax 

Source: GAO analysis. 

a

Various limitations on deducting losses exist for each entity type. S corporation shareholders’ abilities 

to take losses tend to be more limited than owners of partnerships. 

S corporation income is generally subject to a single level of taxation, 

which for many owners means lower total taxes compared to a similarly 

profitable C corporation. As pass-through entities, S corporations list their 

net business income and losses on the Form 1120S but are not generally 

taxed at the entity level; income, losses and deduction items pass through 

to the individual shareholders’ income tax returns, and the individuals are 

taxed on any net income. Owners of partnerships and sole proprietorships 

are also taxed only on their business income at the individual level. In 

contrast, C corporations are subject to double taxation: the corporation is 

taxed on its net business income, and individual shareholders are also 

taxed on dividend income received from the business. 

Being able to offset income on the individual income tax returns with S 

corporation losses and deductions can be an important consideration for 

shareholders who expect and want to obtain tax benefits on those losses 

and deductions. For some perspective on the possible significance of this 

advantage, we analyzed loss and gain patterns in 2001 to 2006 for S 

corporations that took losses in 2003. We found that S corporations that 

took losses in 2003 tended to take losses in other years as well. Of the S 

corporations in the SOI corporate sample that took losses in 2003 and filed 

tax returns in each year from 2001 through 2006, 61 percent took losses in 

4 or more of the 6 years. Additionally, 51 percent took losses in 4 or more 

consecutive years. 

Page 7 GAO-10-195 Noncompliance with S Corporation Tax Rules 
To gain perspective on the degree to which shareholders use S corporation 

losses to offset their other income, we analyzed NRP data on shareholders’ 

2001 Form 1040s. On average, shareholders using losses from S 

corporations in 2001 offset an estimated 16.6 percent of their other income 

with S corporation losses.16 We estimate that 42 percent of the S 

corporation shareholders used a loss from an S corporation to offset other 

income reported on the Form 1040. Many of these shareholders were 

shareholders of multiple S corporations. Of the shareholders reporting S 

corporation losses, we estimated that 11 percent reported losses from 

multiple S corporations, and 29 percent reported income from one or more 

other S corporations. Appendix III provides analysis on S corporation 

losses. 

S corporation shareholders can also take advantage of losses through 

business networks; for example, a shareholder of two S corporations can 

offset income from one S corporation on her individual tax return by 

taking a loss from the other S corporation. Owners of partnerships and 

sole proprietorships benefit from taking losses on their individual returns 

as well. C corporation shareholders, in contrast, cannot directly benefit 

from their business’s losses, since they are taken at the corporate level. 

S corporation owners also may prefer the entity’s possible lower 

employment tax burdens compared to partnerships and sole 

proprietorships. An S corporation pays employment taxes only on wages 

paid to employees, as do C corporations. For officers and other 

shareholders who perform services for the corporation, the S corporation 

is to treat them as employees, determining and paying them an adequate 

wage, referred to as “reasonable compensation.” Shareholders can also 

receive nonwage distributions that are not subject to employment taxes. 

By comparison, general partners of partnerships and owners of sole 

proprietorships generally pay self-employment taxes on the net earnings of 

the business rather than on wages earned.17

 

16For an analysis of loss-taking by sole proprietors, see GAO-09-815, Tax Gap: Limiting 

Sole Proprietor Loss Deductions Could Improve Compliance but Would Also Limit Some 

Legitimate Losses (Washington, D.C.: Sept. 10, 2009). 

17With self-employment tax, individuals pay all of the Social Security and Medicare taxes. 

They get a tax deduction for half of those payments. Limited partners generally do not pay 

self-employment taxes on income allocated to them by the partnership, except for 

“guaranteed payments.” 

Page 8 GAO-10-195 Noncompliance with S Corporation Tax Rules 
As for nontax advantages, limited liability protection was frequently cited 

by stakeholder representatives we interviewed as a compelling reason for 

making a business an S corporation. Corporate status provides limited 

liability protection.18

Less influential nontax reasons for choosing an S corporation that were 

mentioned by stakeholder representatives are corporate image, eligibility 

for certain government contracts, and the relative simplicity of the 

business form. Several representatives mentioned that corporations 

project a more professional image than other entity types, which can be an 

advantage in getting business. Corporate status is required for eligibility 

for certain government contracts, making the S corporation a good choice 

for smaller businesses that want to compete for those contracts. Several 

stakeholder representatives mentioned the relative simplicity of the S 

corporation form, in terms of ease of formation, ease of operation, and 

established case law relative to various other entity types; however, other 

representatives did not agree that this was a significant reason for 

choosing the S corporation entity type. 

Limited Liability 

Protection and Other 

Nontax Benefits Are Also 

Considerations When 

Choosing S Corporations 

Tax Law Changes May 

Have Spurred S 

Corporation Growth 

Before 1986, the highest individual tax rate was higher than the highest 

corporate tax rate; the Tax Reform Act of 198619 reversed this for the next 

seven years (it was reversed again in 1993), expanding the appeal of S 

corporations, whose shareholders pay their taxes at the individual level. 

The Small Business Job Protection Act of 199620 eased several restrictions 

on S corporations, including increasing the maximum number of 

shareholders from 35 to 75 and expanding the type of entities that may be 

S corporation shareholders. These and numerous other changes by these 

two laws to the S corporation tax rules enhanced the appeal of S 

corporation status. S corporations represented less than 6 percent of all 

businesses in 1986, but their share increased substantially in the years 

following the passage of these two laws, reaching about 12 percent in 

2002. 

 

18This reason for choosing S corporation status may be becoming less important with the 

advent of the limited liability company (LLC). LLCs are entities created under state law that 

provide similar limited liability protection to a corporation while offering more flexibility in 

other ways. An LLC may choose to be classified for tax purposes as an S corporation, C 

corporation, partnership, or sole proprietorship. 

19Pub. L. No. 99-514, 100 Stat. 2085 (Oct. 22, 1986) 

20 See Pub. L. No. 104-188, 110 Stat. 1755 (Aug. 20, 1996). 

Page 9 GAO-10-195 Noncompliance with S Corporation Tax Rules 
 The American Jobs Creation Act of 200421 further increased the maximum 

number of shareholders to 100. 

According to the NRP, an estimated 68 percent22 of S corporation returns 

filed for tax years 2003 and 200423 misreported at least one item affecting 

net income.24 For those years, the overall net misreported amount—

accounting for both overreported and underreported amounts—that S 

corporations passed through to individual shareholders was about $85 

billion.25 For context, assuming that the lowest individual income tax rate 

of 10 percent applied to this entire misreported amount, $8.5 billion in lost 

tax revenues for tax years 2003 through 2004 could have been attributable 

to S corporation noncompliance. However, this represents a highly 

simplified calculation that is intended solely to illustrate the potential tax 

impact at the shareholder level from S corporation noncompliance.26

In Tax Years 2003 and 

2004, a Majority of S 

Corporations Were 

Noncompliant with at 

Least One Tax Rule; 

Various Options Exist 

to Address 

Noncompliance 

S corporations varied in the items that they misreported. Beyond net 

income,27 the most frequently misreported line item was “other 

 

21 Pub. L. No. 108-357, 118 Stat. 1418 (Oct. 22, 2004). 

22The 68 percent estimate includes misclassification adjustments where a taxpayer reports 

the correct amount but on the wrong line as well as adjustments where the examiner 

zeroed out the entire return. For comparison with S corporation misreporting, the NRP for 

individuals estimated that 70 percent of sole proprietors in tax year 2001 misreported net 

business income. See Tax Gap: A Strategy for Reducing the Gap Should Include Options 

for Addressing Sole Proprietor Noncompliance, GAO-07-1014 (Washington, D.C.: July 13, 

2007). 

23All estimates from the NRP S corporation underreporting study reflect the total over 2 tax 

years. From the S corporation NRP, 25 percent of the sample came from tax year 2003 and 

75 percent from tax year 2004, but both tax years 2003 and 2004 have equal input into our 

estimates. 

24We used Form 1120S, Schedule K, line 23 for tax year 2003 and line 17e for tax year 2004 

to compute the items affecting S corporation net income that flows through to 

shareholders. 

25Estimate is within +/-12.2 percent of the reported value. 

26This simplified calculation may be too high or too low. A precise estimate would require 

tracing the S corporation noncompliance through to the shareholder’s income tax return to 

compute the ultimate tax loss. Other factors that could affect the estimate include other 

income and loss items on the shareholder return, the shareholder’s ability to claim any S 

corporation losses on the shareholder return, and income taxes owed on shareholder’s 

returns from inadequate wage compensation provided to shareholders by S corporations. 

27Net income is the most frequently misreported and largest misreported line item overall 

because it is a cumulative line item that is affected any time the items that contribute to it 

are adjusted. 

Page 10 GAO-10-195 Noncompliance with S Corporation Tax Rules 
deductions,”28 and among the line items with the largest misreported 

amounts were distributions and gross sales. By median misreported 

amount, noncompliance was the highest in not paying the correct wage 

compensation to S corporation shareholders; this noncompliance was 

much greater than the second highest median misreported amount—

distributions to S corporation shareholders. Table 2 identifies the most 

frequent items that S corporations misreported as well as the amounts 

misreported (in absolute values). 

Table 2: Most Common Misreported Line Items by Number of S Corporations 

Misreporting and Amounts Misreported (Absolute Dollar Values), Tax Years 2003

and 2004 Combined 

Misreported line items 

Number 

misreported 

(in thousands) 

Net 

misreported 

amount 

(in billions)

Median 

misreported 

amount

Net incomea4,542 $84.8c$5,459d

Other deductionsb3,532 37.2c4,204d

Distributionsi1,852 61.8h7,411f

Gross receipts or sales 1,508 25.8h3,988g

Cost of goods sold 1,311 —e 3,003g

Depreciation expense 1,000c5.7h1,755f

Shareholder compensation 887c 23.6d 20,127d

Purchases 801c—e2,031h

Taxes and license expense 651c 1.4g 271h

Repairs and maintenance expense 585c 2.8g 1,505g

Interest expense 574c2.3g985h

Source: GAO analysis of IRS’s NRP data. 

Note: All data in this table are 2-year data (total over tax years 2003 and 2004). Estimates in the table 

have a margin of error within +/-10 percent of the reported value unless otherwise specified. 

a

Misreported net income includes both overstated and understated income items and deductions. As 

a result, some items will increase the net income amount and others will decrease it. 

b

Other deductions include amortization; certain business costs; insurance premiums; legal and 

professional fees; supplies; travel, meal, and entertainment; and utilities. 

c

Estimate is within +/-16 percent of the reported value. 

d

Estimate is within +/-18 percent of the reported value. 

e

Margin of error was too large to generate a reliable estimate. 

f

Estimate is within +/-30 percent of the reported value. 

 

28Other deductions include amortization; certain business costs; insurance premiums; legal 

and professional fees; supplies; travel, meal, and entertainment; and utilities. 

Page 11 GAO-10-195 Noncompliance with S Corporation Tax Rules 
g

Estimate is within +/-41 percent of the reported value. 

h

Estimate is within +/-89 percent of the reported value. 

i

Distributions do not affect S corporation net income. 

The direction of misreporting provided tax advantages for the S 

corporations or their shareholders. Overall, of noncompliant S 

corporations, about 80 percent underreported net income by understating 

income received and/or overstating expenses deducted. For example, as 

shown in table 3, 88 percent of the misreporting of repairs and 

maintenance involved overstating these expense deductions, resulting in 

understated net income. For shareholder compensation, understating 

rather than overstating the expense deduction provides the tax advantage 

because lower wage compensation means paying less in employment 

taxes. Of S corporations that misreported shareholder compensation, 93 

percent understated it.29

Table 3: Percentage of S Corporations Underreporting and Overreporting Common 

Line Items, Tax Years 2003 and 2004 Combined 

Misreported line items 

Percentage 

understated income 

Percentage 

overstated income

Gross receipts or sales 80 20

Percentage 

overstated 

deductions 

Percentage 

understated 

deductions

Other deductionsa91 9

Cost of goods sold 72 28

Depreciation expense 72 28

Shareholder compensationb7 93

Purchases 67 33 

Taxes and license expense 70 30 

Repairs and maintenance expense 88 12 

Interest expense 81 19 

Source: GAO analysis of IRS’s NRP data. 

Notes: All data in this table are 2-year data (total over tax years 2003 and 2004). All estimates in the 

table have a margin of error within +/-8 percentage points. We excluded the distributions line item 

because it may not have a tax impact. In general, distributions received by a shareholder are tax-free 

up to the shareholder’s stock basis. 

 

29For more information about the extent of noncompliance with shareholder compensation, 

see pp. 24-36. 

Page 12 GAO-10-195 Noncompliance with S Corporation Tax Rules 
a

Other deductions include amortization; certain business costs; insurance premiums; legal and 

professional fees; supplies; travel, meal, and entertainment; and utilities. 

b

Understating compensation generally results in underpayment of employment taxes. 

Although S corporation shareholders legitimately can offset other income 

on their individual income tax returns with S corporation losses, some 

shareholders may be claiming S corporation losses that are not valid. For 

tax years 2003 and 2004, IRS’s NRP examiners raised adjustments to 

correct the misreported items on the Form 1120S, which caused some S 

corporations initially reporting a net loss to have net income. As a result, 

an estimated 13 percent of S corporations claiming net losses changed to 

net income after examination, compared to 2 percent that changed from 

net income to losses. We did not have data to trace through how the 

individual tax liabilities of shareholders would change for those who had 

used S corporation losses to offset other income when they actually 

should be adding the S corporation income to their other income on their 

Form 1040.30

Misreporting differed by the number of shareholders, as shown in table 4. 

For example, a higher percentage of single shareholder S corporations 

misreported other deductions compared to those with four or more 

shareholders. 

Table 4: Percentage of S Corporations Misreporting Common Line Items by Number 

of Shareholders, Tax Years 2003 and 2004 Combined 

 Misreported line item 

1 

shareholder

2-3

shareholders

4 or more 

shareholders 

Net income 72 63 53

Other deductionsa 57 48 34

Distributions 30 25 15

Gross receipts or sales 26 18 11

Cost of goods sold 20 20 11

Depreciation expense 16 13 8

Shareholder compensationb15 10 4

Purchases 20 18 11

Taxes and license expense 11 8 6

 

30We reported in 2009 that 70 percent of sole proprietors reporting losses in tax year 2001 

had losses that were either partially or fully noncompliant on the basis of NRP 

examinations. See GAO-09-815. 

Page 13 GAO-10-195 Noncompliance with S Corporation Tax Rules 
 Misreported line item 

1 

shareholder

2-3

shareholders

4 or more 

shareholders 

Repairs and maintenance expense 9 9 6

Interest expense 8 9 6

Source: GAO analysis of IRS’s NRP data. 

Notes: All data in this table is 2-year data (total over tax years 2003 and 2004). All estimates in the 

table have a margin of error within +/-8 percentage points. 

a

Other deductions include amortization; certain business costs; insurance premiums; legal and 

professional fees; supplies; travel, meal, and entertainment; and utilities. 

b

Understating compensation generally results in underpayment of employment taxes. 

Misreporting varied according to the size of S corporations as measured by 

assets. For example, a higher percentage of S corporations with assets 

under $250,000 had at least one adjustment than those with $1 million to 

$10 million in assets.31 Those with assets under $250,000 represented 79 

percent of all S corporations in the sample. 

The S corporation NRP provided an avenue to evaluate noncompliance in 

misreporting certain line items on the 1120S. As shown in table 5, our 

review of 166 randomly selected S corporation returns for tax years 2003 

and 2004 that IRS examined under NRP identified some types of 

misreporting. 

Table 5: Type of Misreporting by S Corporations, Tax Years 2003 and 2004 

Combined 

Type of misreporting 

Number of S 

corporations

Number of 

errors 

Deducted personal expenses 69 169

Did not substantiate the deducted expense 52 122

Deducted expense disallowed for other reasonsa61 101

Did not claim all allowable expenses 41 64

Source: GAO analysis of 166 randomly selected NRP examinations. 

Note: Some S corporations misreported multiple times. For example, an S corporation could have 

deducted expenses without substantiation more than once throughout the tax return. 

a

Other reasons included deducting an expense paid by an external party, deducting toll violation, and 

deducting more than allowable gifts. 

 

31Adjustments for S corporations with assets over $10 million, the highest asset category, 

were not significantly different from those in the under $250,000 category. An IRS official 

noted that the amount of error as a percentage of their income was relatively low. 

Page 14 GAO-10-195 Noncompliance with S Corporation Tax Rules 
The most common type of misreporting was improperly deducting 

personal expenses as business expenses. Of the 166 examination files 

reviewed, we found 69 returns that erroneously deducted one or more 

personal expenses, resulting in 169 total errors.32 These improper 

deductions included payments for personal taxes, personal tax 

preparation, personal insurance, personal vehicles, and other personal 

expenses. Automobile, insurance, telephone, and travel expenses were the 

most commonly misreported personal expenses; for example, we saw 

cases in which taxpayers improperly claimed a personal car insurance 

expense deduction on the Form 1120S. 

The second most common type of misreporting on S corporation tax 

returns we reviewed was not adequately substantiating the expenses. 

According to stakeholder representatives in the S corporation industry, S 

corporations may have neither good bookkeeping nor tax professionals 

that advised them about the importance of bookkeeping under complex S 

corporation tax rules. These representatives also said that new S 

corporations may not have consulted a tax specialist when deciding to 

elect S corporation status, and may not be educated about S corporation 

tax filing requirements. Another representative told us that some 

taxpayers may not be doing bookkeeping for tax purposes until they file 

the 1120S, at which time it becomes a challenge for a preparer to sort out 

the records and help taxpayers file their return. 

S corporations may need a preparer to help them navigate the complex tax 

rules to remain in compliance. However, paid preparers make mistakes 

too. IRS’s NRP results for 2003 to 2004 showed that 81 percent of the S 

corporations used a paid preparer. Differences in estimated 

noncompliance were not statistically significant comparing whether or not 

a paid preparer was involved in preparing the Forms 1120S. We estimated 

that 75 percent of the S corporations that did not use a paid preparer were 

noncompliant while 71 percent of those that used a paid preparer were 

noncompliant. 

To some degree, preparers may contribute directly to S corporation 

noncompliance. IRS examiners sometimes added notes to the NRP 

examination files that attributed the noncompliance to mistakes by 

preparers. For example, in the NRP examination files we reviewed, we 

found notes that attributed 21 misreported items in 14 files directly to 

 

32Some S corporations also had multiple types of misreporting for one line item. 

Page 15 GAO-10-195 Noncompliance with S Corporation Tax Rules 
mistakes by preparers. We do not know to what extent preparers 

contributed to the noncompliance in the other NRP cases absent some 

indication from IRS’s examiners in the case files. On one hand, 

stakeholder representatives told us that some preparers may innocently 

make mistakes because the S corporation does not provide them with full 

and accurate information and records when preparing the Form 1120S. On 

the other hand, representatives said that some preparers may not be 

sufficiently trained to prepare S corporation returns. Also, the preparer for 

the S corporation and individual shareholder returns may be different. IRS 

officials said that when the preparer for the S corporation differs from that 

used by the shareholders, it may be challenging to resolve issues that carry 

across from the entity to the shareholder. 

Properly Calculating Basis 

Is a Challenge for 

S Corporation 

Shareholders 

In addition to S corporation noncompliance, their shareholders may make 

errors related to the S corporation. One type of noncompliance occurs 

when a shareholder uses the S corporation losses beyond their allowable 

stock and debt basis. Since one advantage of choosing S corporation 

status is the ability to offset other income with S corporation losses and 

deductions on the individual income tax return, shareholders who claim 

losses beyond allowable basis are benefiting improperly. S corporation 

stakeholder representatives told us that calculating and tracking basis was 

one of the biggest challenges in complying with S corporation rules. 

To gain further perspective on incorrect basis reporting, we analyzed IRS’s 

annual examinations of individual tax returns that closed for fiscal years 

2006 through 2008. In those examinations, the amount of the misreported 

losses that exceeded basis limitations was over $10 million, or about 

$21,600 per taxpayer. According to IRS examination officials, lack of basis 

is one of the largest issues for an S corporation shareholder’s tax return, 

and they noted that these misreported amounts understate shareholder 

noncompliance because IRS examiners are not fully recording codes in the 

examination database to identify basis misreporting. 

The S corporation NRP examinations could detect an indication of 

noncompliance with basis issues through the Form 1120S but IRS would 

need to audit the Form 1040 to verify that noncompliance. As such, 

shareholder noncompliance was not fully measured because not all 

shareholders from the S corporation NRP were examined. If a shareholder 

owned a 20 percent or more interest in an S corporation reporting a net 

Page 16 GAO-10-195 Noncompliance with S Corporation Tax Rules 
loss, the examiner was required to consider three loss limitation rules—

basis, at-risk, and passive activity.33 Even though estimates are not 

available, IRS officials said that the NRP showed that some shareholders 

did not properly track and report their basis, and as a result, improperly 

used S corporation losses to offset other income on their individual tax 

returns. 

Shareholders are responsible for calculating and tracking basis. While the 

Schedule K-1 sent to shareholders lists some information that can be used 

to calculate basis, S corporations are not required to report any basis 

calculations to shareholders. The only information on how to calculate 

stock basis is on the Schedule K-1 instructions. Specifically, a voluntary 

IRS worksheet in the K-1 instructions can be used to calculate stock basis. 

However, some industry representatives said they do not use the 

worksheet but instead have come to rely on computer software, which 

they said is adequate to calculate stock and debt basis at the entity level, 

and in some cases, provide that calculation to its shareholders. 

IRS Addresses 

S Corporation Tax 

Noncompliance in 

Enforcement and Service 

Programs 

IRS enforces compliance with S corporation rules through document 

matching and examination programs. The Automated Underreporter 

Program (AUR) matches individual tax returns with information return 

documents and assesses taxes on those with significant enough 

discrepancies. For S corporations, AUR matches pass-through income 

reported on the Schedule E of a Form 1040 to the Schedule K-1. For tax 

year 2006, AUR assessed over $49 million on just almost 5,200 taxpayers 

with this mismatch issue, though this number also includes partnerships 

as well as S corporations. The issue ranked 14th out of 56 different AUR 

categories in terms of dollars assessed. 

Examinations are used to check reporting compliance on tax returns, but 

due to limited resources, IRS examines only a small portion of S 

corporations. In fiscal year 2008, IRS examined over 16,000 S corporation 

returns, which equates to less than 0.5 percent of all S corporations filing 

tax returns. Of those examined, the items most commonly examined were 

gross receipts or sales, purchases, shareholder compensation, and other 

 

33For example, the shareholder may not have had enough stock and or debt basis to claim a 

loss from the S corporation or even if they had basis, the at-risk rules may limit loss claims. 

At-risk rules look to the source of funds. Passive activity losses are limited to passive 

income. Passive activities are trade or business activities where the shareholder does not 

materially participate during the year. 

Page 17 GAO-10-195 Noncompliance with S Corporation Tax Rules 
deductions. Due to data reliability concerns, we were not able to analyze 

IRS’s examination results for S corporations, such as how often IRS found 

misreporting and the amount misreported.34

One way that examiners detect S corporation noncompliance is IRS’s yK1 

software program, which uses Schedule K-1 information to graphically 

depict relationships among taxpaying entities. It displays the shareholders 

of S corporations as well as any other businesses that are linked to the 

S corporation, including parent companies and subsidiaries that have 

common shareholders with the S corporation. Starting with a business 

entity or individual shareholder, yK1 can show its connections in sending 

or receiving Schedule K-1s. It shows common use of paid preparers, some 

family relationships (e.g., husband/wife), and common addresses, among 

other linkages. For example, if IRS discovers noncompliance that is 

related to a scheme marketed by a preparer, IRS can use yK1 to identify 

other entities that used the same preparer. In addition to K-1 data, IRS 

pulls data from various IRS databases, such as those showing data from 

filed returns or from information returns filed by third parties. Although 

there have been no formal analyses of yK1’s effectiveness, IRS officials say 

that its examiners report that using yK1 has helped to identify millions of 

dollars in unpaid taxes from entities, including S corporations. For 

S corporations, yK1 data can help examiners determine if the shareholder 

has stock or debt basis, as well as establish trends in officer’s 

compensation. 

IRS aims to educate taxpayers about S corporation rules through its 

service activities. IRS does not have a publication specific to 

S corporations but publishes detailed instructions to Forms 1120S and 

Schedule K-1. IRS also has a toll-free telephone number through which it 

routes callers to a specialist who can answer questions about 

S corporations. IRS’s Web site has a page that provides information on 

S corporation filing requirements, with links to other pages on basis, 

compensation, and shareholders. Finally, IRS sends a letter to newly 

elected S corporations, alerting these entities that S corporations generally 

have to pay adequate compensation and that they should contact IRS or go 

to www.irs.gov for more information. The letter does not communicate 

 

34EOAD had multiple entries of misreporting for a line item and we could not reliably 

determine whether the examiner made a correction at all, much less upward or downward, 

to the line item. IRS officials could not tell us why this occurred or how to resolve these 

multiple entries. This problem did not exist with the examination data from the 1120S NRP. 

Page 18 GAO-10-195 Noncompliance with S Corporation Tax Rules 
basis requirements or direct taxpayers to specific IRS Web sites related to 

S corporations. 

Options Could Help 

Further Address 

S Corporation 

Noncompliance 

As table 6 shows, we developed options for improving compliance with 

S corporation rules based on interviews with S corporation industry 

representatives and IRS officials. 

Table 6: Options for Improving Compliance with S Corporation Rules 

Challenge Options 

Preparer mistakes Investigate ways to improve performance of practitioners 

preparing S corporation returns, such as licensing, education, or 

penalties 

Calculating basis Legislative change to require basis calculation at entity level 

IRS mailing information on basis calculation to new 

S corporations 

IRS issuing clear, concise guidance for calculating debt basis 

Source: GAO analysis. 

IRS could improve compliance by investigating options to reduce preparer 

errors and preparer complicity with noncompliance. Ways to do this 

include licensing, education, and preparer penalties. 

Option to Address Preparer 

Mistakes 

The accuracy of S corporation returns might be improved through the 

regulation of paid preparers, such as legislation that requires preparers 

who work on S corporation returns to be licensed. We reported in 200835

that federal individual tax returns filed by taxpayers in Oregon, which has 

a rigorous preparer licensing requirement, were more likely to be accurate 

compared to those filed by taxpayers in the rest of the country. Preparers 

in Oregon have to pass an open book examination to receive their licenses 

to practice, and about 68 percent of the people taking the examination 

passed. While the people who did not pass cannot legally prepare tax 

returns in Oregon, paid preparers with an equivalent lack of demonstrated 

ability may well be working as paid preparers in other states. Further, the 

IRS Commissioner announced in June 2009 that he will propose a 

comprehensive set of recommendations to help IRS better leverage the tax 

 

35GAO, Tax Preparers: Oregon’s Regulatory Regime May Lead to Improved Federal Tax 

Return Accuracy and Provides a Possible Model for National Regulation, GAO-08-781 

(Washington, D.C.: Aug. 15, 2008). 

Page 19 GAO-10-195 Noncompliance with S Corporation Tax Rules 
return preparer community with the twin goals of increasing taxpayer 

compliance and ensuring high ethical standards of tax preparers. 

Variations on this option could be to require a special certification specific 

to S corporations, or a certification that covers all business returns. One 

tax preparation stakeholder representative said that he has seen preparers 

who primarily work on individual income tax returns prepare an 

occasional Form 1120S return; such preparers may not be sufficiently 

knowledgeable about S corporations, which can lead to mistakes. 

Instituting preparer licensing requirements would increase the likelihood 

that a preparer is qualified to prepare an S corporation tax return. One 

representative said that if he cannot adequately prepare a return, he will 

refer a client to another preparer, but he believes that many preparers 

would prepare the return anyway because they want the income. Another 

representative said that instructions to Form 1120S should state that 

S corporation taxation is a complex area of the law and is different from 

individual tax law, and should suggest that the taxpayer seek guidance 

from a reputable tax consultant in tax return preparation. As IRS develops 

preparer standards, ensuring that S corporation preparers abide by 

different rules than individual preparers would acknowledge the vast 

differences in tax law between these two groups and potentially improve 

preparer performance for its taxpayers. 

Penalties levied on preparers who make mistakes on tax returns are an 

important tool in improving compliance. Similar to preparers of individual 

tax returns, penalties can be asserted for S corporation preparers when 

the tax return they prepared understates tax liability.36 However, one set of 

stakeholder representatives cautioned that the penalties for preparer 

mistakes may not be helping boost compliance with S corporation rules. 

Examiners are limited in asserting penalties on S corporation preparers 

because the penalties are based on the tax liabilities, which is not assessed 

at the entity level but is passed through to shareholders. Thus, the penalty 

for substantial understatement of tax liability generally would not be 

assessed against the preparer of an inaccurate Form 1120S return. 

According to IRS officials, only when an examiner identifies a preparer 

mistake through a shareholder return, such as for basis or passive activity 

loss, would an examiner assess the preparer for penalties. IRS agreed to 

act on our June 2009 recommendation to evaluate penalty administration 

and penalties’ effect on voluntary compliance by developing a plan to 

 

3626 U.S.C. § 6694. 

Page 20 GAO-10-195 Noncompliance with S Corporation Tax Rules 
collect and analyze penalty-related data.37 IRS does not have data to show 

how often penalties are levied on preparers for S corporations compared 

to individuals or other business. Because IRS does not collect these data 

by entity type, its ability to evaluate the penalties related to Form 1120S 

preparers is impeded. 

One option for improving compliance with basis rules is for Congress to 

require S corporations to calculate basis and report each shareholder’s 

basis on Schedule K-1. This could improve compliance to the extent that 

record-keeping and expertise in basis calculations are better at the entity 

level than the shareholder level. IRS officials said that during examinations 

some shareholders are not aware of the basis calculation requirement. 

This option would most likely help bring some S corporations into 

compliance by requiring that the calculation be explicitly reported to both 

shareholders and IRS. In addition, it likely would be most useful for 

S corporations with multiple shareholders since, for instance, the business 

and the shareholder are the same in single-shareholder S corporations. 

Some larger S corporations already report basis information to their 

shareholders, according to a stakeholder representative. 

Options to Improve Calculation 

of Basis 

The least burdensome way for S corporations to calculate basis for their 

shareholders would be to limit the required calculation to information 

already possessed by the S corporations; the shareholder would be 

required to know about and track the information missing from 

S corporations’ calculations. The other way would be to require 

S corporations to obtain as much missing information from each 

shareholder as possible in order to more fully calculate stock and debt 

basis. This would be more burdensome on S corporations but would be 

more helpful to shareholders, especially if shareholders are less likely than 

S corporations to know what information is needed. Because some 

S corporations’ tax return programs already compute shareholders’ stock 

and debt basis, the additional burden is minimized. This requirement is 

similar to that which will require brokers to track basis on investments for 

their clients.38

 

37GAO, Tax Administration: IRS Should Evaluate Penalties and Develop a Plan to Focus 

Its Efforts, GAO-09-567 (Washington, D.C.: June 5, 2009). 

38See section 403 of the Emergency Economic Stabilization Act of 2008, Pub. L. No. 110-343, 

122 Stat. 3765 (Oct. 3, 2008); GAO, Capital Gains Tax Gap: Requiring Brokers to Report 

Securities Cost Basis Would Improve Compliance If Challenges Are Addressed, 

GAO-06-603 (Washington, D.C.: June 13, 2006). 

Page 21 GAO-10-195 Noncompliance with S Corporation Tax Rules 
Such missing information at the S corporation level could include a 

shareholder’s initial cost to buy stock from another shareholder, and the 

value of stock on the date of death for inheritances. According to IRS 

officials and an S corporation stakeholder representative, information on 

stock resale can be readily attained by the entity. Currently, shareholders 

must inform an S corporation of the date and amount of shares transferred 

to update ownership information and enable the S corporation to properly 

allocate income and losses between shareholders. It may not be a 

significant extra burden to require shareholders to also report the cost of 

the stock to the corporation at the time of acquisition. IRS officials told us 

that it is not common for only shareholders to possess such basis-related 

information. However, some industry representatives cautioned that 

requirements like these would create work for S corporations, and that 

information on the cost of stock sold or inherited should not be provided 

to S corporations in order to preserve shareholder privacy. 

In addition, partnerships are required to report a similar calculation on 

their Schedule K-1s to their partners. Partnerships are to report capital 

account39 and liability information that can be used as an approximate 

calculation for basis.40 S corporations’ shareholders do not have a capital 

account, although the Schedule K-1 does require the entities to report 

items affecting basis. Stakeholder representatives told us that having 

similar reporting for S corporations as with partnerships would make 

sense and improve compliance. 

A second option to increase compliance with basis rules is for IRS to send 

information on basis calculations to newly elected S corporations. Rules 

could be distributed by U.S. mail, e-mail, or both. While some industry 

representatives told us that they thought most new S corporation owners 

would not understand how to track basis and would not pay attention to 

IRS information about basis, other representatives told us that it would at 

least alert these new S corporation owners that they have to keep track of 

something, even if they don’t know how to track it. The owners might then 

hire an accountant who would keep track of basis. Information sent to 

 

39A capital account reflects each partner’s equity in the partnership, including each 

partner’s capital contribution and profits. 

40While not designed for the purposes of calculating basis, many industry representatives 

told us that they can use the partnership K-1s to track basis. The partnership K-1 includes 

checkboxes for the capital account information, of which tax basis is one option. 

According to IRS officials, even checking the other options would provide a rough 

approximation for partnership basis. 

Page 22 GAO-10-195 Noncompliance with S Corporation Tax Rules 
newly elected S corporations could also provide specific guidance on 

appropriate record keeping. 

Another option to aid taxpayers in computing shareholder basis is for IRS 

to publish a clear, one or two-page guidance sheet for calculating debt 

basis. We developed this option based on input from some industry 

representatives that additional guidance on basis would improve 

compliance as well as from IRS officials who indicated the need for such a 

worksheet. According to IRS officials, determining valid debt basis is a 

major challenge in calculating shareholder basis. The only IRS information 

for shareholders on calculating their basis is an IRS worksheet in the K-1 

instructions on calculating stock basis. A similar worksheet for calculating 

debt basis might aid taxpayers and preparers in correctly calculating their 

full basis but its impact may be limited. Some industry representatives told 

us that they do not use this stock basis worksheet as tax preparers for S 

corporations generally use professional tax software to calculate basis at 

the entity level, and provide the results to the corporation’s shareholders. 

Thus, it is difficult to know whether a similar worksheet on debt basis 

would increase compliance directly or indirectly. Further, the complexity 

of issues involved in calculating debt basis would not easily lend itself to a 

simplified worksheet. IRS officials who tried to develop a concise debt 

basis worksheet said that too many variables confounded their effort. 

However, guidance is among the least costly ways to improve taxpayer 

compliance, so this option could be cost-effective even if only a small 

percentage of taxpayers made use of the guidance. IRS officials stated that 

such impacts would be enhanced if the law was simplified to make debt 

basis part of stock basis; doing so would decrease the complexities and 

help taxpayers comply with basis rules, but also would materially change 

the essence of the current S corporation law. 

Page 23 GAO-10-195 Noncompliance with S Corporation Tax Rules 
Unlike other types of business entities, S corporations have a possible 

avenue, whether used unintentionally or intentionally, to avoid 

employment taxes on payments made to shareholders. S corporation 

shareholders can receive both wages and distributions; but only wages are 

subject to employment taxes that are to be paid by both the S corporation 

and those receiving wages. 41 As a result, S corporations that improperly 

pay lower shareholder wages while increasing other payments such as 

distributions to shareholders, lower employment tax liabilities. 

S corporation shareholders who provide labor as employees of the 

S corporation are subject to employment taxes on their reasonable 

compensation. Generally, an officer of an S corporation is considered to 

be an employee of the corporation for federal employment tax purposes,42

and thus employment taxes must be paid on an estimate of “reasonable” or 

adequate shareholder wage compensation.43 However, the difficulty and 

subjectivity in determining what constitutes an adequate wage enables 

some S corporations to pay inadequate wage compensation for the labor 

provided and compensate their officers through higher amounts of 

distributions, payments of personal expenses, and/or loans. 

Inadequate Wage 

Compensation to 

S Corporation 

Shareholders Creates 

Employment Tax 

Noncompliance, 

Which Could be 

Addressed through 

Legislative or 

Administrative 

Changes 

Compared to S corporations, other entity types operate under different 

employment tax rules.44 For example, partnerships and sole 

proprietorships are not subject to the same employment tax liabilities as 

are S corporations. Specifically, general partners and sole proprietors are 

not employees for which employment taxes are to be paid based on wages. 

Instead, they are considered to be self-employed and must pay selfemployment tax on all net earnings derived by the entity.45 Therefore, the 

 

4126 U.S.C. §§ 3121(a) (FICA), 3306(b) (FUTA). 

4226 U.S.C. § 3121(d); Rev. Rul. 73-361, 1973-2 C.B. 331. However, an officer of a corporation 

who does not perform any services or performs only minor services and who neither 

receives nor is entitled to receive, directly or indirectly, any remuneration is considered not 

to be an employee of the corporation. 26 C.F.R. § 31.3121(d)-1(b). 

43IRS will recharacterize distributions provided in lieu of an adequate compensation for 

services performed by shareholders as wages for employment tax purposes. Rev. Rul. 74-

44, 1974-1 C.B. 287. 

44Regardless of entity type, employers are required to withhold from the wages of all 

employees, including corporate officers and others who are paid to perform services, 

amounts for income tax liability and employment taxes, and provide a matching share of 

employment taxes. 

4526 U.S.C. § 1401; 26 C.F.R. § 1.1401-4(c). 

Page 24 GAO-10-195 Noncompliance with S Corporation Tax Rules 
partner or sole proprietor is not able to take an inadequate wage to 

improperly reduce their employment tax liabilities. 

Some S Corporations Pay 

Inadequate Shareholder 

Compensation and Avoid 

Employment Taxes 

According to NRP data for tax years 2003 and 2004, about 13 percent of S 

corporations paid inadequate wage compensation, resulting in just over 

$23.6 billion in net underpaid wage compensation to shareholders.46 To 

illustrate the potential impact on employment tax revenue loss from 

paying inadequate wages, we applied the maximum Federal Insurance 

Contributions Act (FICA) tax rate of 15.3 percent to the net underpayment 

amount to compute a simplified calculation of around $3 billion in 

employment tax revenue losses over tax years 2003 and 2004. Being just 

for illustrative purposes, this simplified calculation could be too high or 

too low because it did not attempt to account for all factors that affect 

employment taxes. For example, all income above the FICA maximum 

($106,800 in 2009) is taxed at a lower 2.9 percent rate, which would lower 

the tax figure.47 The net effect could be understated because we excluded 

the 6.2 percent federal unemployment tax due on the first $7,000 in wages. 

Further, because NRP cannot detect all noncompliance, net effects could 

be understated.48

S corporations with the fewest shareholders made up the largest portion 

of shareholder compensation net underpayments. For example, single 

shareholder S corporations accounted for most of the net underpayments 

and those with one to three shareholders accounted for almost all of the 

net underpayment as shown in figure 2.49 The median misreporting 

adjustment for underpaid shareholder compensation in all categories was 

$20,127.50

 

46For the 2-year total, the net $23.6 billion accounts for $24.6 billion in understated wages 

and $1 billion in overstated wages. 

47Wages beyond the FICA maximum are subject to taxes for Medicare. 

48Along with these constraints, this estimate could be high or low due to other taxpayer 

filing errors that could increase or offset net tax losses and could not be identified in our 

analysis. For example, though very infrequent, taxpayers may have reported shareholder 

compensation on the wrong line, which could distort underpayment estimates. 

49The estimates for each shareholder number group in Figure 2 will not sum to $23.6 billion 

because $1.2 billion in adjustments were associated with S corporations without a 

shareholder count. The negative figure for the 4 or more shareholder group means that IRS 

examiners determined that as a whole, this group was overpaid wages. 

50Estimate is within +/-17.4 percent of the reported value. 

Page 25 GAO-10-195 Noncompliance with S Corporation Tax Rules 
Figure 2: Net Value of Adjustments for Shareholder Compensation in Billions, by 

Number of Shareholders, Tax Years 2003 and 2004 Combined 

Total adjustments (in billions of dollars)

Source: GAO analysis of IRS’s 2003 and 2004 S Corporation NRP data.

Number of shareholders

-2

0

2

4

6

8

10

12

14

16

1 2 to 3 4 or more

14.2

8.3

-0.2

Current Law Does Not 

Facilitate Consistent 

Taxpayer Compliance for 

Adequate Shareholder 

Compensation 

The vagueness of federal tax law on determining adequate wage 

compensation for shareholders means that the facts and circumstances 

have to be analyzed in each case. Doing so increases the burden for 

S corporations to determine adequate compensation and creates 

opportunities for avoiding employment taxes by paying inadequate 

compensation. A 2005 TIGTA report found that determining adequate 

compensation was complex and subjective.51

Neither the Internal Revenue Code nor Treasury Regulations have specific 

guidelines for determining reasonable compensation. However, the 

determination of reasonable compensation has been extensively litigated, 

and courts generally evaluate the facts and circumstances of the case to 

decide whether the wages paid were adequate for the service performed. 

In examining reasonableness, the courts apply various judicially developed 

 

51Treasury Inspector General for Tax Administration, Actions Are Needed to Eliminate 

Inequities in the Employment Tax Liabilities of Sole Proprietorships and SingleShareholder S Corporations, Reference no. 2005-30-080 (Washington, D.C.: May 20, 2005).

Page 26 GAO-10-195 Noncompliance with S Corporation Tax Rules 
factors, although no single factor is considered determinative or more 

universally important. 

According to IRS examination officials, the lack of a clear legal standard 

and the need to consider various facts and circumstances has made it 

difficult for IRS to develop comprehensive guidance on what constitutes 

an adequate wage amount. Instead IRS’s only guidance for taxpayers is a 

list of nine factors provided on August 2008 that various courts have 

generally considered in determining adequate compensation on the basis 

of the facts and circumstances of a case:52

• training and experience, 

• duties and responsibilities, 

• time and effort devoted to the business, 

• dividend history, 

• payments to nonshareholder employees, 

• timing and manner of paying bonuses to key people, 

• what comparable businesses pay for similar services, 

• compensation agreements, and 

• the use of a formula to determine compensation. 

In addition to IRS officials, a majority of stakeholder representatives 

indicated that taxpayers were uncertain on how to meet requirements for 

paying shareholder compensation. Further, three of the nine stakeholder 

groups that we spoke with stated that inadequate shareholder 

compensation was one of the biggest compliance problems and that 

determining adequate shareholder compensation was highly subjective 

and depended on a number of different factors. Further, nearly all of the 

stakeholder representatives also indicated that having specific IRS 

guidance would be helpful for taxpayers and preparers. 

IRS Enforcement of 

Adequate Shareholder 

Compensation Has Been 

Limited 

Several IRS examiners told us that arriving at a justifiable conclusion 

about what constitutes adequate compensation can be difficult, time 

consuming, and result in a relatively low tax adjustment for the work 

involved. In determining adequate shareholder compensation, IRS 

examiners that we interviewed stated that they look at a variety of factors. 

However, due to the difficulties in determining adequate shareholder 

compensation, examiners said that they tend to only pursue the issue in 

the most egregious cases where shareholders are paid little to no wages 

 

52IRS Fact Sheet, FS-2008-25 (August 2008). 

Page 27 GAO-10-195 Noncompliance with S Corporation Tax Rules 
and receive large distributions. A 2002 TIGTA report found that IRS 

examiners did not always address officer compensation, even when little 

to no compensation was paid.53

IRS efforts to enforce the rules on paying adequate wage compensation to 

S corporation shareholders have been limited, as shown in table 7.54 In 

analyzing IRS annual examination data for fiscal years 2006 through 2008, 

we found that IRS only examined 0.5 percent or less of the S corporations 

that filed Form 1120S. IRS examined shareholder compensation usually in 

well less than a quarter of these examinations over these years. 

Table 7: Estimated Number of S Corporation Examinations with Shareholder 

Compensation Issues, Examinations Closed in Fiscal Years 2006 to 2008

2006 2007 2008

Number of S corporations filing Form 1120S 3,715,249 3,909,730 4,155,830

Number of S corporations examined 13,970 17,657 16,634

Number of S corporations examined for 

shareholder compensation 

2,004 3,819 2,597

Percentage of all S corporations examined 0.4 0.5 0.4 

Percentage of S corporation examinations that 

covered adequate compensation 

14.3 21.6 15.6

Source: GAO analysis of IRS’s Databook and EOAD data, fiscal years 2006-2008. 

Note: In general, examination activity is associated with returns filed in the previous calendar year. 

The number of S corporations examined for shareholder compensation does not include all instances 

when employment tax returns (Form 941s) are examined. 

When examining shareholder compensation in the NRP study, the 

examiners generally did not document much analysis of the adequacy of 

the wages paid. In our review of randomly selected NRP examination files, 

we found evidence of some kind of analysis to determine adequacy in 24 of 

114 examinations where we noted that IRS determined that shareholder 

 

53Treasury Inspector General for Tax Administration, The Internal Revenue Service Does 

Not Always Address Subchapter S Corporation Officer Compensation During 

Examinations, Reference No. 2002-30-125 (Washington, D.C.: July 5, 2002). 

54Due to data limitations, we were only able to determine the number of times that 

examiners looked at shareholder compensation and were unable to determine how often 

an adjustment was made, or the amount of the adjustment. 

Page 28 GAO-10-195 Noncompliance with S Corporation Tax Rules 
compensation needed review.55 These analyses included benchmarking 

tools such as monster.com, salary.com, and Bureau of Labor Statistics 

(BLS) wage data. In the other 90 examinations, examiners did not 

document an analysis, and in some cases merely reconciled an officer’s 

W-2 form to the return. Examiners made adjustments in 10 of the 24 cases 

where documentation showed that an analysis had been made and in 16 of 

the other 90 cases. In these 26 examinations with adjustments due to 

inadequate shareholder compensation, the adjustment amount averaged 

$30,000. 

Shareholder Compensation 

Issues Can be Addressed 

Through Legislative 

Options, but Potential 

Trade-offs Exist 

Given the concerns of S corporations paying inadequate wage 

compensation to shareholders to avoid employment tax obligations and 

the burden in determining adequate compensation, legislative options have 

been suggested by knowledgeable groups such as the Joint Committee on 

Taxation and TIGTA. We analyzed the potential trade-offs in terms of the 

pros and cons of each option by meeting with representatives of nine 

organizations involved with S corporations including tax lawyers, tax 

accountants, and tax preparers as well as IRS officials. The pros and cons 

for each option are described qualitatively and are not intended to be 

exhaustive or weighted. As a result, we are not ranking or otherwise 

making recommendations on the value of each option. Appendix 1 

discusses in more detail how we identified the options as well as the 

related trade-offs in terms of potential pros and cons. 

The options we reviewed provide a different standard for determining 

employment tax liability than the subjective facts and circumstances 

criteria used to determine adequate shareholder compensation for 

employment tax purposes. To the extent that a new standard is clearer, 

S corporations and their shareholders could determine employment tax 

liability with less uncertainty and administrative burden, which would help 

ensure compliance in paying the correct employment tax amount. 

Similarly, clearer criteria would also help IRS examiners ensure 

compliance in paying all employment taxes. However, these options also 

include trade-offs such as increased taxes for certain S corporations and 

shareholders that could offset the advantages of S corporation status. 

Table 8 shows the options and their variations. 

 

55Returns in the NRP study generally experience a higher level of examination for certain 

noncompliance issues such as shareholder compensation than during normal annual 

operations. 

Page 29 GAO-10-195 Noncompliance with S Corporation Tax Rules 
Table 8: Legislative Options to Address Shareholder Compensation 

Type of option Option variations 

Basing employment tax 

liability for shareholders on 

the net business income 

reported by S corporations 

• Make net business income subject to employment 

taxes 

• Make net business income for service sector 

businesses subject to employment taxes 

• Make net business income for majority shareholders 

subject to employment taxes 

Basing employment tax 

liability on all types of 

payments made to active 

shareholders 

• Make payments to active shareholders subject to 

employment tax 

• Make payments to active shareholders up to a dollar 

tolerance subject to employment tax 

Retain character of income • Retain character of income between entities 

Source: GAO analysis of interviews and documents. 

The first set of options attempts to reduce the burden on S corporations 

for paying the correct amount of employment taxes because they have to 

determine adequate wage compensation for each shareholder. Rather, 

similar to sole proprietors and partnerships, the basis for employment tax 

liability is shifted to the net business income reported by the S 

corporation. Table 9 lays out the pros and cons from using the net 

business income concept for employment tax purposes. 

Table 9: Identified Pros and Cons of Basing Employment Tax Liability For 

Shareholders on the Net Business Income Reported by S Corporations 

Pros Cons 

Simplifies burden by shifting to a new 

basis for employment taxation. 

Can be considered to be unfair to impose 

employment tax on income that is generated 

beyond the services provided by a 

shareholder for the S corporation. 

Increases uniformity of employment tax 

treatment by conforming S corporations 

and shareholders to the rules for sole 

proprietorships and general partners. 

Shareholders could still potentially 

manipulate their returns to avoid employment 

taxes such as by incorrectly reporting a net 

business loss or reclassifying their business 

activity. 

Reduces the chances for shareholders to 

disguise compensation as distributions, 

loans, or personal payments to avoid 

employment taxation. 

S corporations may have difficulty raising 

capital if investor returns would be lower 

from having the employment tax liability. 

Source: GAO analysis of interviews and documents. 

From our interviews with S corporation stakeholder representatives and 

IRS officials, we analyzed three variations in using the net business income 

Page 30 GAO-10-195 Noncompliance with S Corporation Tax Rules 
as the basis for employment tax liability. These variations and additional 

pros and cons are discussed below. 

Make Net Business Income Subject to Employment Taxes. The first 

variation in using net business income as the basis for shareholders’ 

employment tax liabilities in lieu of determining adequate compensation 

for each shareholder would make S corporation net income (whether or 

not distributed) subject to self-employment tax.56 Doing so would put the 

shareholder’s employment tax liability on par with the treatment given 

general partners in partnerships and to sole proprietorships. Furthermore, 

a 2005 JCT report estimated that this option could raise tax revenues by 

approximately $57.4 billion over 10 years (fiscal years 2005 to 2014).57

However, including all net business income instead of just the wages paid 

to specific shareholders for the labor provided to S corporations was 

generally opposed by stakeholder representatives. Some stakeholder 

representatives stated that this shift in the method for determining 

employment taxation would be very dramatic or would effectively end the 

use of S corporation status. Additionally, some stakeholders also said that 

this option would be viewed as unfair for those shareholders whose 

income is not based on labor services provided to the S corporation. 

Make Net Business Income for Service Sector Businesses Subject 

to Employment Taxes. The second variation would have similar pros 

and cons but attempt to narrow the negative impact on shareholders who 

provide little or no labor to the S corporation. That is, it would only apply 

to service sector S corporations,58 making their net business income 

(whether or not distributed) subject to self-employment tax.59 The 

stakeholder representatives expressed more comfort with this variation 

compared to the first because the employment taxes would be more likely 

applied to income derived from services and labor, rather than capital 

investment, assuming that S corporations providing services are more 

 

56Joint Committee on Taxation, Options to Improve Tax Compliance and Reform Tax 

Expenditures, JCS-02-05 (Washington, D.C.: Jan. 27, 2005). Following the rules for 

partnerships, this option would exclude certain income such as rental income, dividends, 

and interest. 

57JCS-02-05. 

58Generally, service sector S corporations would include activities such as health, law, 

engineering, architecture, accounting, actuarial science, performing arts, or consulting. 

59Joint Committee on Taxation, Additional Options to Improve Tax Compliance 

(Washington, D.C.: Aug. 3, 2006). 

Page 31 GAO-10-195 Noncompliance with S Corporation Tax Rules 
likely to have income generated from the labor of shareholders. In general, 

stakeholder representatives still opposed this option. Not all shareholders 

in these service corporations would necessarily provide labor services and 

other nonshareholder employees could be generating profits for the S 

corporation. Furthermore, those S corporations that are generally 

nonservice businesses would still have to determine adequate 

compensation for each shareholder. Finally, S corporations might escape 

this provision by simply misstating business activity as something other 

than a “service” business. 

Make Net Business Income for Majority Shareholders Subject to 

Employment Taxes. The third variation for basing employment taxation 

on the net business income of the S corporation would be limited to only 

majority shareholders (those holding more than 50 percent of the stock in 

an S corporation).60 This would approximate the self- employment taxation 

of sole proprietors. As a result, majority S corporation shareholders and 

sole proprietors would be put on equal footing for employment tax 

purposes. According to 2006 SOI data, 60 percent of all S corporations are 

owned by just one shareholder with almost 90 percent owned by one to 

two shareholders. Further, this option would help address problems with 

single shareholder S corporations, which have a higher incentive to 

underpay shareholder wages because their wage determinations are 

unilateral and can be structured to avoid employment taxes. For example, 

sole proprietors pay employment taxes on their total profits while 

shareholders who are the only shareholder of an S corporation are to pay 

employment taxes on only the amounts that they unilaterally select as 

their wages. This option does not change the current employment tax 

treatment of shareholders that hold 50 percent or less of the corporation. 

As a result, S corporations would still have to determine adequate 

compensation for those shareholders. Further, shareholders could reduce 

their level of ownership to less than 50 percent. In addition, it is possible 

that some majority shareholders provide little or no labor to the 

S corporation. 

The second set of options shifts the basis for employment tax liability from 

having to determine adequate wage compensation to focusing on all types 

of payments made to just active shareholders. Table 10 lists the basis pros 

and cons of this set of options. 

 

60TIGTA 2005-30-080. 

Page 32 GAO-10-195 Noncompliance with S Corporation Tax Rules 
Table 10: Identified Pros and Cons of Basing Employment Tax Liability on All Types 

of Payments Made to Active Shareholders 

Pros Cons 

Reduces burden of determining adequate 

compensation. 

Imposes employment taxes on money taken 

out of S corporation even if the shareholder 

has enough basis for a tax free distribution or 

pays back a loan. 

Increases uniformity of employment tax 

treatment by conforming S corporations 

and active shareholders to rules for sole 

proprietorships and general partners. 

Shareholders may be mischaracterized as 

“non-active,” or not involved in the operation 

of the S corporation to avoid taxation. 

Reduces the chances for shareholders to 

disguise compensation as distributions, 

loans, or personal payments to avoid 

employment taxation. 

S corporations may funnel money through 

another pass-through entity to disguise 

active participation. 

Only taxes money taken out of the 

corporation, which increases the 

likelihood for a return on capital. 

May be unfair to impose employment taxes 

on income generated beyond the services of 

a shareholder. 

Source: GAO analysis of interviews and documents. 

Our work with the S corporation stakeholder representatives and IRS 

officials analyzed two variations for this set of options. The related pros 

and cons are discussed below for these two variations. We then discuss an 

additional legislative option that attempts to deal with one tax loophole 

related to the “character of income.” 

Make Payments to Active Shareholders Subject to Employment 

Tax. The first variation would focus on shareholders who actively 

participate in the operation of an S corporation and who would owe 

employment taxes based on all payments that they received from the 

S corporation including wages as well as personal payments, distributions, 

or loans. This option provides broad coverage in reducing the burden of 

determining adequate compensation and addresses the issue that the 

business should get some return on capital without being taxed on the 

investment income the shareholder leaves in the business. However, 

stakeholder representatives had some concerns with such coverage. For 

example, they said that loans made to shareholders who later pay off the 

loan should not be treated as income on which employment taxes are paid. 

As with the earlier set of options, they expressed concerns about imposing 

employment taxes on income generated from capital invested rather than 

labor provided. Furthermore, some active S corporation shareholders 

might still avoid taxation by treating themselves as “inactive”. 

Page 33 GAO-10-195 Noncompliance with S Corporation Tax Rules 
Make Payments to Active Shareholders Up to a Dollar Tolerance 

Subject to Employment Tax. The second variation would have similar 

pros and cons but would attempt to limit some negative effects by 

inserting a dollar tolerance for all payments made to active shareholders. 

That is, for any shareholder who actively participates in the operation of 

an S corporation, all payments up to either the FICA maximum ($106,800 

in 2009) or up to some other dollar amount such as double the FICA 

maximum ($213,600 in 2009) are considered compensation for 

employment tax purposes. S corporations and shareholders pay lower 

taxes by not paying employment taxes on all compensation. By limiting 

the amount of payments from the S corporation subject to employment 

taxation, active shareholders who have invested capital could receive a 

distribution free of employment taxation. In addition, this method would 

create a safe harbor for taxpayers wishing to ensure their compliance with 

shareholder compensation rules but who are uncertain of the correct 

income figure to report. On the other hand, this option would greatly limit 

flexibility in certain situations. For example, the dollar tolerance does not 

account for differences in payments made to active shareholders that are 

prompted by differences in the type of industry and geographic location, 

or other factors. 

Retain Character of Income Between Entities. The last option we 

analyzed does not change the current-law basis for the employment tax 

obligations of shareholders. Rather, it attempts to eliminate one potential 

method that can be used to avoid employment taxation by using an 

S corporation to shelter business income from partnerships. Specifically, a 

partner in a partnership would attempt to circumvent the self-employment 

rules of partnerships by inserting an S corporation between the 

partnership and the individual. Under this option, income that flows from 

a partnership to an S corporation will retain its self-employment tax 

character until it is passed to an individual. By retaining the character of 

the income for employment tax purposes until it reaches the individual, 

fewer opportunities for “gaming” the system exist. However, this option 

only addresses one specific “loophole” and can add some complexity to 

track the income through different entities. 

Administrative Options 

May Help to Decrease 

Inadequate Compensation 

Issues for S Corporations 

In addition to legislative options, we identified two administrative options 

that may help address issues involving inadequate shareholder 

compensation issues while avoiding some of the cons identified above. 

Currently, taxpayer compliance and IRS oversight are hindered partly 

because of the absence of a standardized way to determine reasonable 

compensation on a consistent basis. Additionally, the lack of taxpayer 

Page 34 GAO-10-195 Noncompliance with S Corporation Tax Rules 
education on shareholder compensation rules may also increase 

noncompliance according to some stakeholder representatives. To 

address these challenges, we identified these two administrative options 

as well as their related pros and cons which are discussed below. 

Improve guidance to IRS examiners so that they might better 

target and determine adequate shareholder compensation. An 

example of the improved guidance would be to improve examiner use of 

tools for making adequate compensation determinations. During our 

review of randomly selected NRP IRS examination case files, we found 

that in 23 cases, examiners indicated the use of some form of analysis 

including 15 cases where they used salary data from the BLS or other 

salary tools as a benchmark for making the adequateness determination. 

In those cases where we saw evidence of analysis of shareholder 

compensation, examiners made adjustments 10 out of 23 times. When 

examiners used BLS statistics, they adjusted shareholder compensation 6 

of 9 times. Thus, it appears that using such a tool could improve the 

effectiveness of IRS examinations of shareholder compensation. While the 

Internal Revenue Manual (IRM), IRS’s official guidance resource, requires 

examiners to document their case review, it does not require them to 

conduct an analysis of shareholder compensation using tools such as BLS 

statistics. Additionally, the IRM does not require examiners to indicate 

why an analysis was not used in cases where it is excluded. An analysis, 

however, would not reduce the subjectivity and burden for those S 

corporations attempting to comply with federal rules and would not 

completely address the difficulty examiners face. For example, IRS 

officials noted that a shareholder may perform duties for the S corporation 

that do not align well with occupation categories available in salary 

benchmarking tools or may live in a location without comparable wage 

data. 

Better educate taxpayers and provide guidance on meeting 

shareholder compensation tax obligations. TIGTA has recommended 

sending out prefiling information to taxpayers newly electing 

S corporation status. Some shareholder representatives told us that some 

taxpayers may not be aware of the need to pay officer compensation. For 

example some shareholder representatives noted that taxpayers or tax 

preparers were not certain about how to meet shareholder compensation 

requirements and could benefit from additional guidance through means 

such as additional outreach including providing information to new 

S corporations on shareholder compensation and improving the guidance 

on IRS’s Web site. Even though IRS has noted that developing 

comprehensive guidance for S corporations can be difficult, such outreach 

Page 35 GAO-10-195 Noncompliance with S Corporation Tax Rules 
to these unaware taxpayers could help them better determine adequate 

compensation for its shareholders, including those who provide capital to 

the S corporation but little or no labor. IRS already provides some training 

materials to its examiners on determining adequate compensation that 

goes beyond the factors developed through case law; however, these 

materials are not publicly available. For example, these materials 

encourage the use of wage benchmarking tools from third parties to help 

determine adequate compensation. Providing specific guidance such as 

this could potentially improve compliance by clarifying this issue for both 

taxpayers and tax preparers. Again, this better education and guidance 

would not resolve the subjectivity and burden associated with the “facts 

and circumstances” test. 

The high percentage of noncompliant S corporations leads to substantial 

lost tax revenue for the federal government. Whether mistakes are 

intentional or unintentional, misreporting is unfair to compliant taxpayers 

and undermines the equity of the tax system. The high rate of misreporting 

associated with S corporation returns done by paid preparers raises 

concerns about their competency to deal with the tax complexities arising 

from S corporation status. New S corporation owners and their preparers 

may not have the appropriate skills to ensure compliance with tax rules, 

which can require diligent record keeping and complex basis calculations. 

Further, the lack of guidance on determining shareholder compensation is 

challenging for both taxpayers and IRS examiners. Without clear guidance 

or legal requirements, S corporations tend to underpay shareholder wages, 

resulting in underpaid employment taxes for funding programs like 

Medicare and Social Security. Nor are IRS examiners fully documenting or 

using tools that may assist them to analyze whether adequate 

compensation had been paid. Several options could help address these 

challenges, either through legislative or administrative change, although 

each option has its trade-offs. Any of these options should be paired with 

continued attention to taxpayer service and education. 

To improve compliance with shareholder basis rules, Congress should 

require S corporations to calculate and report shareholder’s stock and 

debt basis as completely as possible. S corporations would report the 

calculation on the Schedule K-1 and send it to shareholders as well as IRS. 

If Congress judges that stock purchase price information that is currently 

only available to shareholders should not be transmitted to the 

S corporation due to privacy concerns, an alternative is to require that 

S corporations report less complete basis calculations using information 

already available to the S corporation. 

Conclusions 

Matter for 

Congressional 

Consideration 

Page 36 GAO-10-195 Noncompliance with S Corporation Tax Rules 
Recommendations To help address the compliance challenges with S corporation rules, we 

recommend that the Commissioner of Internal Revenue take the following 

four actions: 

• Identify and evaluate options for improving the performance of paid 

preparers who prepare S corporation returns, such as licensing preparers 

and ensuring that appropriate penalties are available and used. 

• Send additional guidance on S corporation rules and record-keeping 

requirements to new S corporations to distribute to their shareholders, 

including providing guidance on calculating basis and directing them to 

the specific IRS Web site related to S corporation tax rules. 

• Require examiners to document their analysis such as using comparable 

salary data when determining adequate shareholder compensation or 

document why no analysis was needed. 

• Provide more specific guidance to shareholders and tax preparers, such as 

that provided to IRS examiners, on determining adequate shareholder 

compensation through means such as IRS’s Web site. 

IRS’s Deputy Commissioner for Services and Enforcement provided 

written comments on a draft of this report in a December 4, 2009, letter, 

which is reprinted in appendix IV. IRS staff also provided technical 

comments, which we incorporated into the report as appropriate. The 

written comments acknowledged that S corporations represent one of the 

fastest growing types of businesses, that their tax misreporting can 

produce income tax and employment tax revenue losses, and that tax 

administration and compliance efforts involving S corporations can be 

challenging. 

Agency Comments 

IRS agreed in principle with our four recommendations. Regarding the 

performance of paid tax preparers working on S corporation returns, IRS 

agreed with the need to identify and evaluate options to improve the 

preparers’ performance and noted that by year end a team convened by 

the IRS Commissioner would make recommendations to strengthen 

oversight of tax return preparers overall. As for our recommendation on 

sending additional guidance to new S corporations, IRS agreed to evaluate 

the need for additional information to be provided on calculating stock 

and debt basis. Our work with S corporation stakeholders and our review 

of IRS examinations of the basis issue indicated that more information 

about calculating basis is needed. IRS also agreed to modify its 

correspondence to new S corporations to direct them to IRS’s Web site. In 

addition, IRS agreed to ensure that examiners meet workpaper 

documentation requirements involving their analysis of comparable salary 

data when determining adequate shareholder compensation. IRS was 

Page 37 GAO-10-195 Noncompliance with S Corporation Tax Rules 
silent on the second part of our recommendation under which IRS also 

would ensure that examiners document their rationale when they 

determined no analysis was needed. Our review of examiners’ workpapers 

indicated a need for documenting why no analysis was done. We found 

evidence of an analysis for just 24 of the 114 examinations involving 

shareholder compensation, leaving open the questions of whether 

examiners did an analysis for the other 90 examinations and if they did, 

why they had not documented the analysis. Finally, IRS agreed to provide 

on its Web site (IRS.gov) more specific guidance to all S corporation 

shareholders and tax preparers on such items as recordkeeping 

requirements and determining adequate shareholder compensation. 

As agreed with your offices, unless you publicly announce its contents 

earlier, we plan no further distribution of this report until 30 days after its 

date. At that time, we will send copies of this report to the Chairman and 

Ranking Member, House Committee on Ways and Means; the Secretary of 

the Treasury, the Commissioner of Internal Revenue, and other interested 

parties. This report is available at no charge on GAO’s Web site at 

http://www.gao.gov. 

If you or your staffs have any questions about this report, please contact 

me at (202) 512-9110 or brostekm@gao.gov. Contact points for our Offices 

of Congressional Relations and Public Affairs may be found on the last 

page of this report. Key contributors to this report are listed in appendix V. 

Michael Brostek 

Director, Tax Issues 

Strategic Issues Team 

Page 38 GAO-10-195 Noncompliance with S Corporation Tax Rules 
Appendix I: Scope and Methodology Appendix I: Scope and Methodology 

Our objectives were to: (1) describe reasons a business might choose to 

become an S corporation; (2) analyze the types of S corporation 

noncompliance, what the Internal Revenue Service (IRS) has done to 

address the noncompliance overall, and options for improvement; and 

(3) further analyze the extent of noncompliance involving a long-standing 

concern over inadequate shareholder compensation, and identify options 

for improving compliance. 

To provide background information on the size and growth of S 

corporations, we used IRS Statistics of Income (SOI) corporate, 

partnership, and individual data for tax years 2000 to 2006 to compare 

characteristics of S corporations to other business types. We compared 

our results with the published SOI files and determined our data were 

reliable for the purposes of our review. 

To describe reasons for a business to choose S corporation status, we 

reviewed relevant literature from sources such as the Joint Committee on 

Taxation (JCT), Treasury Inspector General for Tax Administration 

(TIGTA), and the Congressional Research Service (CRS). We interviewed 

IRS officials from the Large/ Mid-Size Business Division (LMSB), the Small 

Business/ Self-Employed Division (SBSE), Accounts Management, and 

Field Assistance. We also interviewed representatives of industry 

organizations that have experience with S corporations, specifically: S 

Corporation Association (SCA), National Society of Accountants (NSA), 

National Association of Enrolled Agents (NAEA), Small Business Council 

of America (SBCA), American Institute of Certified Public Accountants 

(AICPA), American Bar Association (ABA), National Association for the 

Self Employed (NASE), National Federation of Independent Business 

(NFIB), and National Small Business Association (NSBA). Using the 

information gathered from these sources, we determined tax and nontax 

considerations businesses might use to choose a business entity election 

and used these considerations to compare the business entity types. To 

analyze the ability of S corporations to pass through losses to their 

shareholders, we used the Corporate Master File for tax years 2001 to 2006 

to extract data on the number and attributes of S corporations reporting 

losses. We restricted our analysis to S corporations that reported losses in 

2003 and filed tax returns in each year 2001 to 2006. The last line on the 

Form 1120S Schedule K, titled Income/Loss Reconciliation in 2006, is the 

amount that is carried over onto shareholders’ Form 1040s as losses. 

However, Corporate Master File data for that line only go back to 2004. To 

analyze losses from 2001 to 2006, we used the 1120S Ordinary Income and 

Loss line to measure whether an S corporation took a loss. We also used 

the 2001 Individual National Research Program (NRP), a study of 

Page 39 GAO-10-195 Noncompliance with S Corporation Tax Rules 
Appendix I: Scope and Methodology 

individual taxpayer returns conducted by IRS, to provide general 

information on how shareholders use S corporation income to offset other 

income. Based on our assessment, we determined that the Corporate 

Master File and Individual NRP database were sufficiently reliable for the 

purposes of our review. 

To analyze the types of S corporation noncompliance, we used data from 

the 2003 and 2004 S Corporation NRP. The NRP sample is divided across 

12 strata by the type of S corporation tax return filed and asset classes. 

IRS accepted as filed some of the NRP returns, accepted others with minor 

adjustments, and examined the remainder of returns either through 

correspondence or face-to-face meetings with taxpayers. If IRS examiners 

determined that taxpayers misreported any aspect of the selected tax 

returns, they adjusted the taxpayers’ income accordingly and assessed 

additional taxes. Misclassification adjustments, where a taxpayer reports 

the correct amount but on the wrong line, are included in our analysis, as 

are cases where the examiner zeroed out the entire return. All estimates 

from the NRP S corporation underreporting study reflect the total over 2 

tax years. From the S corporation NRP, 25 percent of the sample came 

from tax year 2003 and 75 percent from tax year 2004, but both tax years 

2003 and 2004 have equal input into our estimates. 

We also reviewed a random, nongeneralizable sample of 166 noncompliant 

cases from the S Corporation NRP to further illustrate the detailed reasons 

for noncompliance. These 166 cases were all returns with at least one 

adjustment. We requested 186 cases in May 2009, and received 175. We 

omitted 9 cases from our sample: 5 did not contain enough information to 

determine reasons for adjustments, and 4 were out of scope. We recorded 

information from the case files using a data collection instrument (DCI) 

that we developed. To ensure that our data collection efforts conformed to 

GAO’s data quality standards, each DCI entry that a GAO analyst 

completed was reviewed by another GAO analyst. The reviewers 

compared the data recorded within the DCI entry to the data in the 

corresponding case file to determine whether they agreed on how the data 

were recorded. When the analysts’ views on how the data were recorded 

differed, they met to reconcile any differences. 

For this assessment, we interviewed IRS officials about the data, collected 

and reviewed documentation about the data and the system used to 

capture the data, and compared the information we collected through our 

case file review to corresponding information in the NRP database to 

identify inconsistencies. Based on our assessment, we determined that the 

Page 40 GAO-10-195 Noncompliance with S Corporation Tax Rules 
Appendix I: Scope and Methodology 

2003 and 2004 S Corporation NRP data were sufficiently reliable for the 

purposes of our review. 

To determine what IRS has done to address the noncompliance, we 

interviewed IRS officials, and reviewed data from the Automated 

Underreporter program to determine the extent of IRS’s enforcement 

efforts. We also used the Examination Operational Automated Database 

(EOAD) for tax years 2006 to 2008. Due to data reliability issues, we could 

only report data on how often a tax return was examined. Specifically, 

there were multiple entries in EOAD for one misreporting item where we 

could not determine whether the examiner made a correction upward, 

downward, or no correction to the line item. IRS officials could not tell us 

why or how to resolve these multiple entries. Beyond these limitations, we 

determined for the purposes of this review that the data we reported were 

reliable. 

To determine some options for improvement, we interviewed IRS officials 

and conducted two rounds of interviews with stakeholder representatives 

from the S corporation industry. In the first round we compiled a list of 

issues relating to S corporation noncompliance and potential options for 

addressing noncompliance. In the second round, we provided the list 

compiled in the first round to the stakeholders and asked whether or not 

the stakeholders agreed that an issue was a problem, whether or not they 

agreed with the proposed solutions, and discussed the tradeoffs associated 

with each option. These issues, options, and trade-offs are not an 

exhaustive list but represent our analysis and the general views of a 

knowledgeable community related to S corporations. We also collected 

information from IRS’s Web site and service programs. 

To examine the extent to which shareholder compensation contributes to 

S corporation noncompliance, we also used data from the S Corporation 

NRP and the EOAD. We also reviewed the types of shareholder 

compensation analysis conducted by IRS examiners in the sample of 166 

cases we reviewed. To determine options for improving compliance on 

shareholder compensation, we spoke with experts and knowledgeable 

individuals on S corporation shareholder compensation issues. These 

experts included IRS technical advisors and other relevant staff as well as 

knowledgeable representatives for various national organizations that 

represent S corporations, tax return preparers or tax lawyers. From this 

work, we consolidated the list of options. Based on prior GAO reports on 

similar issues, a literature review of other reports, and discussions with 

the parties mentioned above, we developed a list of criteria for evaluating 

the options: equity, taxpayer impact and burden, simplicity, transparency, 

Page 41 GAO-10-195 Noncompliance with S Corporation Tax Rules 
Appendix I: Scope and Methodology 

feasibility, and return (whether the option unduly limits potential financial 

returns for S corporations). We then spoke with stakeholders a second 

time to develop a list of pros and cons for each option based on these 

criteria. All percentage estimates in this report have 95 percent confidence 

intervals that are within +/- 8 percentage points of the estimate itself, 

unless otherwise specified. All other estimates in this have 95 percent 

confidence intervals that are within +/- 10 percent value of the estimate 

itself, unless otherwise specified. We conducted this performance audit 

from May 2007 to October 2009 in accordance with generally accepted 

government auditing standards. Those standards require that we plan and 

perform the audit to obtain sufficient, appropriate evidence to provide a 

reasonable basis for our findings and conclusions based on our audit 

objectives. We believe that the evidence obtained provides a reasonable 

basis for our findings and conclusions based on our audit objectives. 

Page 42 GAO-10-195 Noncompliance with S Corporation Tax Rules 
Appendix II: Tr

Corporations 

ends in the Growth of S 

Page 43 GAO-10-195 Noncompliance with S Corporation Tax Rules 

Appendix II: Trends in the Growth of S 

Corporations 

S corporations are the second most common type of business, as shown in 

figure 3. In tax year 2006, 12.6 percent of all businesses were S 

corporations. The rate of growth of S corporations from tax year 2000 to 

tax year 2006 was 35 percent, while the rate of growth across all business 

types was 23 percent. 

Number of S Corporations 

Figure 3: Number of Businesses by Business Type, Tax Years 2000 to 2006 

Nonfarm sole proprietorship

S corporation

Partnership

C corporation

0

5

10

15

20

25

2000 2001 2002 2003 2004 2005 2006

Millions

Source: GAO analysis of IRS’s Statistics of Income (SOI) data.

Tax year

Number of Shareholders Most S corporations are held by three or fewer shareholders. In tax year 

2006, 60 percent of S corporations were single-shareholder businesses, 89 

percent had two or fewer shareholders, and 94 percent had three or fewer 

shareholders. 

From tax years 2000 to 2006, growth in the number of S corporations with 

three or fewer shareholders exceeded growth in the number of S 

corporations with four or more shareholders. Additionally, as shown in 

figure 4, S corporations held by three or fewer shareholders accounted for 

the majority of S corporation assets, net income, gross business receipts, 

and deductions in 2006, and S corporations held by a single shareholder 
Appendix II: Trends in the Growth of S 

Corporations 

accounted for over 30 percent of S corporation assets, net income, gross 

business receipts, and deductions. 

Figure 4: Share of Total Net Income, Business Receipts, Deductions, and Assets by 

Number of Shareholders, Tax Year 2006 

4 or more shareholders

3 shareholders

2 shareholders

Single shareholder

Source: GAO analysis of IRS’s SOI data.

0

10

20

30

40

50

60

70

80

90

100

Deductions

receipts

Gross business

Net income

Assets

31

19

9

41

22

9

29

26

11

28

25

11

28

39 36 33

Percentage

Note: Columns may not sum to 100 because of rounding. 

Page 44 GAO-10-195 Noncompliance with S Corporation Tax Rules 
Appendix II: Trends in the Growth of S 

Corporations 

Conversions As shown in figure 5, between 78,000 to 97,000 C corporations converted 

to S corporations each year from 2000 to 2006, 1 representing 23 to 31 

percent of new S corporations each year. 

Figure 5: Newly Elected S Corporations, Tax Years 2000 to 2006 

0

50

100

150

200

250

300

350

400

2000 2001 2002 2003 2004 2005 2006

Thousands of businesses

Tax year

Conversions from C corporations

New businesses

Source: GAO analysis of IRS’s SOI data.

Note: Estimates for new businesses are within +/-9 percent of the reported values. Estimates for 

conversions from C corporations are within +/-14 percent of the reported values. 

 

1

 Estimates are within +/-14 percent of the reported value. 

Page 45 GAO-10-195 Noncompliance with S Corporation Tax Rules 
Appendix III: Analy

Losses 

sis of S Corporation 

Page 46 GAO-10-195 Noncompliance with S Corporation Tax Rules 

Appendix III: Analysis of S Corporation 

Losses 

Since nearly 70 percent of S corporations are noncompliant with tax rules 

and the vast majority of these underreported income, many likely took a 

loss when they should have reported a profit or increased the size of the 

loss. Because S corporation shareholders can not only offset S corporation 

income, but other income too (within limits), S corporation owners’ 

noncompliance can “shelter” other income. S corporations that take losses 

tend to take them in multiple years, and S corporation shareholders that 

took losses on their tax returns in 2001 offset an average of 16.6 percent of 

their income with those losses. Median losses for S corporations in tax 

years 2001 to 2006 ranged from $277,000 to $352,000.1

We examined loss and gain patterns in 2001 to 2006 for S corporations that 

took ordinary losses in 2003. Twenty-eight percent of the 45,450 

S corporations in the 2003 SOI sample (12,651 S corporations) took losses. 

Of these, GAO analyzed the 9,152 that filed returns in all 6 years 2001 to 

2006, to facilitate a multiyear analysis. 

Loss-Taking at the S 

Corporation Level 

Of these 9,152 S corporations, 24 percent took losses in all 6 of the years, 

and 79 percent took losses in at least 3 of the 6 years, as shown in table 11. 

Additionally, 51 percent took losses in 4 or more consecutive years, as 

shown in table 12. 

Table 11: S Corporations Taking Ordinary Losses in Multiple Years, Tax Years 2001 

to 2006 

Based on 9,152 S corporations that took losses in tax year 2003a

Percent of S corporations claiming losses in 2003 that claimed losses in all 5 

other years 2001-2006 

24.02

Percent of S corporations claiming losses in 2003 that claimed losses in 4 

other years 2001-2006 

18.36

Percent of S corporations claiming losses in 2003 that claimed losses in 3 

other years 2001-2006 

19.07

Percent of S corporations claiming losses in 2003 that claimed losses in 2 

other years 2001-2006 

17.65

Percent of S corporations claiming losses in 2003 that claimed losses in 1 

other year 2001-2006 

13.02

Percent of S corporations claiming losses in 2003 that claimed losses in no 

other years 2001-2006 

7.85

Source: GAO analysis of IRS Corporate Master File data. 

 

1

Adjusted to 2009 dollars. 
Appendix III: Analysis of S Corporation 

Losses 

a

12,651 S corporations took losses in tax year 2003; GAO performed this multiyear loss analysis on 

the 9,152 of those that filed tax returns in all 6 years 2001- 2006. 

Table 12: S Corporations Taking Ordinary Losses in Consecutive Years, Tax Years 

2001 to 2006 

Based on 9,152 S corporations that took losses in tax tear 2003

Percent of S corporations claiming losses in 2003 that claimed losses in all 6 

years 2001-2006 

24.02

Percent of S corporations claiming losses in 2003 that claimed losses in 5 

consecutive years 2001-2006 

9.81

Percent of S corporations claiming losses in 2003 that claimed losses in 4 

consecutive years 2001-2006 

16.81

Percent of S corporations claiming losses in 2003 that claimed losses in 3 

consecutive years 2001-2006 

17.66

Percent of S corporations claiming losses in 2003 that claimed losses in 2 

consecutive years 2001-2006 

17.13

Percent of S corporations claiming losses in 2003 that did not have 

consecutive years of losses in 2001-2006 

14.53

Source: GAO analysis of IRS Corporate Master File data 

S corporation losses were substantial, as shown in table 13, ranging from a 

median loss of about $277,000 in 2003 to a median loss of about $352,000 in 

2004.2

 Total losses claimed for all S corporations taking losses in 2003 

were $11.4 billion. 

S corporations that took losses in 2003 were more likely to take losses in 

2002 and 2004 than in 2001, 2005, and 2006, as shown in table 13, which is 

not surprising since businesses tend to have periods of greater and lesser 

success that span multiple consecutive years. 

Table 13: S Corporation Ordinary Losses, Tax Years 2001-2006, for S Corporations that Took Losses in 2003

2001 2002 2003 2004 2005 2006

Number of S corporations claiming losses 5,200 5,966 9,071a6,068 5,134 5,076

Percentage of S corporations claiming losses 57 65 99a66 56 55

Median size of S corporation losses (in 2009 dollars) $278,380 $307,938 $277,178 $351,782 $307,287 $310,124

Source: GAO analysis of IRS’s Corporate Master File data. 

Note: Dollar amounts are adjusted to 2009 dollars. 

 

2

Amounts are adjusted to 2009 dollars. 

Page 47 GAO-10-195 Noncompliance with S Corporation Tax Rules 
Appendix III: Analysis of S Corporation 

Losses 

a

9,152 S corporations that took losses in 2003 were identified using IRS SOI data, and information on 

these businesses for tax years 2001 to 2006 was obtained from IRS Corporate Master File data. Due 

to minor discrepancies between these data sources, only 99% (9,071) are identified in the Corporate 

Master File as taking losses in 2003. 

S corporation losses varied by number of shareholders, as shown in figure 

6. In general, the trend is that S corporations with fewer shareholders are 

more likely to take losses, with the exception that very large S 

corporations with 51 or more shareholders are most likely to take losses. 

Figure 6: S Corporation Loss Taking By Number of Shareholders, Tax Year 2006 

Percentage taking losses

Source: GAO analysis of IRS’s Corporate Master File data.

Number of shareholders

0

10

20

30

40

50

60

70

1 2 3 4-5 6-10 11-50 51+

An analysis of shareholder Forms 1040 shows how taxpayers can benefit 

from taking S corporation losses. Based on an analysis of NRP data, 42 

percent of taxpayers who were S corporation shareholders took a loss in 

2001, with a median loss amount of $6,930.3

 As shown in table 14, total 

claims for all taxpayers were $40.2 billion.4

 Most losses were nonpassive: 

35.7 percent of taxpayers with S corporations claimed nonpassive losses, 

Loss-Taking at the 

Shareholder Level 

 

3

Median loss estimate is within +/-23 percent of the reported value. 

4

Total dollar estimate is within +/-17 percent of the reported value. 

Page 48 GAO-10-195 Noncompliance with S Corporation Tax Rules 
Appendix III: Analysis of S Corporation 

Losses 

with only 5.1 percent claiming passive losses. Nonpassive losses were also

larger, with a median claim of $7,412, compared to a median of $2,978 for 

passive losses.5

Table 14: Total and Median Ordinary Losses Claimed by S Corporation 

Shareholders, Tax Year 2001 

g: ta

P

taxpa

Tot

Taxpayers claimin (bill c

Number of 

xpayers

ercentage 

of 

yers 

al losses 

claimed 

ions)

Median 

losses 

laimed

Passive loss only 147,011 5.10 $3.14 $2,978a

Nonpassive loss only 1,028,434 35.65 $ $7,41 32.21 2a

Both passive and nonpassive loss 45,217 1.57 $4.8 - 4 a

No loss 1,663,852 57.68 - - 

Total 2,884,514 100.00 $40.19 - 

Source: GAO analysis of IRS’s 2001 NRP data. 

Notes: Percentage estimates are within +/-3 percentage points. Estimates of numbers of taxpayers 

are within +/-37 percent of the reported value. Total dollar estimates are within +/-49 percent of the 

passive losses only, 

onpassive losses only, and both passive and nonpassive losses) was $6,930. 

ere 

claimed by shareholders reporting losses for only one S corporation.7

laiming losses, 29 percent 

claimed gains from a different S corporation. 

 

reported value. Median dollar estimates are within +/-58 percent of the reported value. 

a

The overall median loss for taxpayers claiming losses (including taxpayers with 

n

Of shareholders claiming losses, 11.3 percent claimed losses for more than

one S corporation. These shareholders claimed much greater amounts in 

losses, with a median of $27,929 claimed in losses, compared to $5,797 for

shareholders claiming losses for only one S corporation.6

 Nonetheless, of 

the total dollars of losses claimed ($40.2 billion), most ($25.5 billion) w

Some S corporation shareholders may use losses from one S corporation 

to offset gains from another. Of shareholders c

5

Estimate for non-passive loss is within +/-25 percent of the reported value, and estimate 

for passive loss is within +/-58 percent of the reported value. 

6

Estimate for shareholders with multiple losses is within +/-37 percent of the reported 

value, and estimate for shareholders claiming losses for only one S corporation is within 

+/-27 percent of the reported value. 

7

Estimate for total losses is within +/-17 percent of the reported value, and estimate for 

shareholders claiming losses for only one S corporation is within +/-16 percent of the 

reported value. 

Page 49 GAO-10-195 Noncompliance with S Corporation Tax Rules 
Appendix III: Analysis of S Corporation 

Losses 

On average, shareholders taking losses from S corporations in 2001 offset 

16.6 percent of their income with S corporation losses. See table 15 for 

amounts of offset broken down by income brackets. 

Table 15: Percentage of Non-S-Corporation Income Offset by S Corporation Losses, 

Tax Year 2001 

Non-S-corporation income bracket 

Percentage of other income offset by 

S corporation loss

Less than $50,000 Estimate unreliable

 $50,000 - $100,000 17.6

$100,000 - $250,000 20.4

Over $250,000 10.9

Total 16.6

Source: GAO analysis of IRS’s 2001 NRP data. 

Page 50 GAO-10-195 Noncompliance with S Corporation Tax Rules 
Appendix IV: Comments from the Internal Appendix IV: Comments from the Internal Revenue Service 

Revenue Service 

Page 51 GAO-10-195 Noncompliance with S Corporation Tax Rules 
Appendix IV: Comments from the Internal 

Revenue Service 

Page 52 GAO-10-195 Noncompliance with S Corporation Tax Rules 
Appendix V: 

A

GAO Contact and Staff 

cknowledgments 

Page 53 GAO-10-195 Noncompliance with S Corporation Tax Rules 

Appendix V: GAO Contact and Staff 

Acknowledgments 

Mike Brostek (202) 512-9110 or brostekm@gao.gov 

In addition to the contact named above, Tom Short, Assistant Director; 

Jeff Arkin; Amy Bowser; Sara Daleski; Dewi Djunaidy; Elizabeth Fan; Katie 

Freeman; Eric Gorman; George Guttman; Kara Marshall; Veronica 

Mayhand; Brittni Milam; John Mingus; Karen O’Conor; Amy Radovich; 

David Reed; Matthew Reilly; Anne Stevens; Meredith H. Trauner; Brian 

Tremblay; Jim Ungvarsky; Walter Vance; Nick Weeks; and Jennifer Li 

Wong made key contributions to this report. 

GAO Contact 

Acknowledgments 

(450584) 
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