The Internal Revenue Service will boost the number of audits it performs of Subchapter S corporations, according to the Associated Press.

The IRS plans to examine later this year 5,000 randomly selected S corporation returns from the 2003 and 2004 tax years, the wire service reported. The agency expects to finish the audits within two to three years.

An S corporation tax status is favorable for small businesses since, while it allows for the same liability as more traditional C corporations, it enables companies to avoid double taxation: the situation in which both the company and its shareholders are taxed. Instead, income is passed directly through to the stockholders, who alone may be taxed on it. What’s more, shareholders can offset business losses incurred by the corporation against their own income.

An IRS spokesperson told AP that S corporations will have to show their financial records to IRS examiners, who will decide whether income and expenses were accurately reported and the correct tax paid. There’s no difference, he said, between such audits and those of other business types.

The government plans to take the data and analyze it to gauge how compliant companies are with tax law, AP reports. From there, it will determine if changes need to be made in tax policy or the Internal Revenue Code.

S corporations are limited to 100 shareholders, and all the members of a family can count as a single shareholder, the newswire notes. Other restrictions stipulate that shareholders must be U.S. citizens or resident aliens and that no other company or partnership can own shares in the corporation.

One aspect of Subchapter S reporting that the IRS has already begun scrutinizing is the compensation of employees who are shareholders, according to a tax analyst quoted by AP. The service is checking, for instance, whether employee shareholders are forgoing a salary or reporting artificially low pay in favor of a big dividend. It’s also looking into whether employees are doing such things to reduce or to eliminate self-employment taxes; such practices are illegal, the news service story noted.

Another tax restriction on S corporations: They can’t take deductions for their employee shareholders’ health insurance. Instead, employees must take the deductions themselves.

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