IRS faulted on tracking partnership, S corp income

The IRS can’t account for the exact amount of misreported income from partnerships and closely-held so-called “S corporations,” estimated to average of tens of billions in misreported income annually.

Investigators at the Government Accountability Office uncovered about $16 billion in misreported income in 2011 and 2012, mostly stemming from corporate partnerships. Between partnerships and shareholder corporations, the watchdog found an estimated $91 billion in questionable income reports between 2006 and 2009.

“There is substantial uncertainty surrounding the extent of income misreporting by partnerships and S corporations themselves, and by the individual taxpayers to whom the income is allocated,” the GAO’s report, released Friday, concluded.

Partnerships and S corporations do not have to pay taxes on income to the IRS themselves but instead allocate income or losses to their shareholders or partners, who then must include that income or loss on their income tax returns.

The last study conducted by the IRS found that S corporations misreported about 15 percent of their income, an average of $55 billion, in 2003 and 2005.

However, the agency can’t determine the exact amount of misrepresented income because at least 3 to 22 percent of the flagged income reports were may have been double-counted as a result of discrepancies in partnership allocations and recordkeeping.

According to the GAO, the IRS doesn’t even know how the faulty income reporting affects taxes paid by partners and the agency does not have a strategy in place to improve the situation.

There is one simple solution to the problem, according to the GAO. If all partnership and S corporation line items were filed electronically then the process to select and examine possibly faulty returns would be much simpler for the agency.

“Congress should consider expanding the mandate for partnerships and corporations to electronically file their tax returns to cover a greater share of filed returns,” the watchdog urged in its report.

In addition, the GAO recommended that the IRS increase its sample of S corporation and partnership returns to examine. While the agency currently examines up to 1.6 percent of C corporations and nearly 2 percent of returns from non-farm sole proprietorships that did not claim income tax returns, the IRS only selects 0.5 percent of S corporation and partnership filings to examine.

In their response, officials at the IRS expressed concerns regarding corrective actions that would require a significant and costly use of its resources.