The IRS Is Intensifying Its Pass-Through Entity Auditing

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The IRS has committed substantial new resources specifically to increase auditing of pass-through entities. Also described as flow-through entities, these are business types where any profits pass through to the owner to be taxed at the individual tax rate. They aren't subject to federal income tax.

The new IRS approach will have important pass-through tax impacts, including limited liability corporation, or LLC, tax implications. It also contrasts strongly with past practice. Audit rates of these business types fell from 3.8% in 2010 to 0.1% in 2019. Now, anyone filing pass-through income may face significantly higher chances of an IRS audit.

Who is impacted

This new approach could potentially impact large numbers of higher-income taxpayers. According to the Tax Policy Center, indications for the 2022 tax year were that more than 90% of net pass-through income would be reported by tax units in the top 20% of income distribution, with well over half of this income reported by taxpayers in the top 1%.

Pass-through business entities are widespread in the US. They were estimated to employ around 43% of the workforce in 2021.

Why are they called pass-through businesses?

They're called pass-through businesses because their profits pass through the business to be recorded on the owners' personal tax returns and taxed at an individual income tax rate. This is different from C corporations, which pay federal business income tax on profits at 21% before any income goes to shareholders. This income is then taxed again at the individual rate, resulting in double taxation.

Which businesses are categorized as pass-through entities?

Pass-through entities fall into four categories: S corporations, or S corps, LLCs, partnerships and sole proprietorships.

• S corps: S corps pass corporate income, losses, deductions and credits through to their shareholders for federal tax purposes, enabling the entity to avoid double taxation on the corporate income.
• LLCs: LLCs are categorized as an entity for state law purposes. There's no single LLC tax regime. An LLC can choose which tax treatment it would prefer on Form 8832. Although the default position subjects the LLC to a partnership tax treatment, the LLC may elect to be treated as an S or C corporation. If it's a single-member LLC, it defaults to sole proprietorship.
• Partnerships: Partnerships are considered pass-through entities because they aren't required to pay corporate income tax. Any profits or losses flow to the partners.
• Sole proprietorships: Sole proprietorships are owned and operated by a single individual who reports business proceeds as income and pays tax on that income at the individual income tax rate.

Why are pass-through businesses so numerous?

The single-taxation basis of pass-through business income is attractive. Businesses eligible for pass-through entity tax can also avoid the $10,000 cap on deducting state and local taxes on federal individual tax returns. Individuals with pass-through business income may also benefit from the Section 199A pass-through deduction.

These advantages may explain the growth in pass-through business filings, particularly from larger businesses. The IRS confirmed a 70% jump in filings from pass-through businesses with over $10 million in assets between 2010 and 2019.

Why is the IRS increasing focus on pass-through businesses?

In June 2024, the IRS said it would look closely at pass-through businesses—and partnerships in particular—so it can "reverse long-term compliance declines that have allowed high-income taxpayers and corporations to hide behind complexity to avoid paying taxes."

Here's an outline of the actions taken by the IRS regarding pass-through entities.

• September 20, 2023: Plans officially announced to establish a special area to focus on large or complex pass-through entities.
• June 17, 2024: New guidance was issued that's designed to stop partnerships using sophisticated tax-free transactions that "lack economic substance," the IRS says.
• October 22, 2024: The new pass-through field operations unit began looking at pass-through entities of every size and form.

What action is required—and when

The new IRS teams have been operational for 6 months. It will take time for data on their specific activities and impact to become available. However, work has already started on complex partnership audits, with 75 of the country's biggest partnerships being audited and compliance letters being sent to 500 others.

The IRS has shown clear intent to intensify its oversight of pass-through entities. If needed, check the pass-through status of any business you're associated with. If you file income derived from a business categorized as pass through, it's important to continue to closely monitor the situation. You may want to consider taking steps to become audit-ready and prepare for the possibility of receiving a compliance letter from the IRS. A compliance letter isn't a notice of a full audit and offers an opportunity to address any possible discrepancies ahead of further action.

Who should you talk to now

You may want to discuss pass-through tax—including LLC tax implications—in more detail with your CPA, tax advisor or attorney. Talk to your First Citizens Wealth consultant, who can bring tax specialists into the conversation.