March 19, 2025
Pass-through entities (PTEs), including partnerships, S corporations, and certain LLCs, make up a large share of U.S. businesses. These structures offer tax advantages by allowing income and losses to “pass through” to owners, avoiding double taxation at the corporate level. Despite the tax advantages, there are several rules that must be carefully followed including the reasonable salary requirement. Maintaining compliance with these regulations is essential to avoid any IRS scrutiny. This is especially important because the IRS has announced an expected increase in the number of partnership audits. With the renewed attention, businesses should be aware of key audit risk factors that can trigger an examination. To help clients, prospects, and others, Wilson Lewis has provided a summary of the key details below.
Types of Pass-Through Entities
Pass-through entities come in different forms, each with its own tax treatment, ownership structure, and compliance requirements. Audit risks also vary depending on the entity type.
Sole Proprietorships are the simplest form of pass-through business. The owner reports all income and expenses directly on their individual tax return. There is no legal separation between the business and its owner, meaning the owner is personally liable for all debts and obligations. While easy to set up and operate, this structure does not offer liability protection.
Key audit risks: Overstated deductions such as home office deductions and travel expenses.
Partnerships involve two or more owners who share profits, losses, and responsibilities. They file an informational tax return and issue Schedule K-1s to each partner, detailing their share of income, deductions, and credits. Partnerships allow flexibility in how income and losses are allocated, but it needs to be properly documented. Partners are also subject to self-employment taxes on their earnings unless they are classified as limited partners. Key audit risks: Failure to track partner basis and improper reporting of related-party transactions such as loans between partners and the business.
S Corporations (S Corps) provide a balance of liability protection and pass-through taxation. Unlike sole proprietorships and partnerships, S Corps must meet IRS eligibility requirements, including a cap of 100 shareholders and restrictions on ownership types. A key tax distinction is that S Corp owners who actively work in the business must pay themselves a reasonable salary, subject to payroll taxes, before taking additional distributions. This helps prevent tax avoidance strategies that minimize payroll tax obligations.
Key audit risks: Owners taking low or no salaries to avoid payroll taxes and distributions that exceed the basis.
Limited Liability Companies (LLCs) are unique in that they are not taxed as a specific entity type by default. Instead, an LLC can elect how it wants to be taxed. A single-member LLC is taxed like a sole proprietorship, while a multi-member LLC is taxed as a partnership unless it elects to be treated as an S Corporation or even a C Corporation. This flexibility allows business owners to choose the most favorable tax treatment.
Key audit risks: Combining business and personal finances, particularly for single-member LLCs.
Why Pass-Through Entities Face Audits
Pass-through taxation allows businesses flexibility in allocating income and deductions, but that flexibility can also lead to compliance risks. The IRS often reviews returns for discrepancies between reported income and expenses, improper loss deductions, and misclassified payments.
Some of the most common audit triggers include:
- Misreporting partner or shareholder income
- Unreasonable compensation or distributions
- Failure to report guaranteed payments
- Excessive deductions
- Large losses year after year
- Misclassification of workers as independent contractors instead of employees
Another growing concern is fraudulent tax credit claims, particularly among self-employed individuals. Misinformation about a so-called ‘Self-Employment Tax Credit’ has spread online, misleading taxpayers into filing claims for a credit that does not exist. These claims often reference the Credits for Sick Leave and Family Leave, which apply only in specific situations. Filing an improper claim could lead to an audit, penalties, and repayment demands from the IRS.
Key Areas of IRS Scrutiny
When auditing a pass-through entity, the IRS typically focuses on a few core areas:
- Income and Deductions — The agency will check that all revenue is reported, and deductions are properly substantiated. Overstated expenses or missing income reports can raise red flags.
- Partner/Shareholder Basis — Owners must track their basis (financial investment) in the business, which determines how much loss they can deduct and whether distributions are taxable. Inaccurate basis calculations often lead to compliance issues.
- Income and Loss Allocations — Pass-throughs must follow their operating agreements and tax rules when distributing income or losses among owners. The IRS may challenge allocations that seem out of sync or lack proper documentation.
- Related Party Transactions — Transactions between the business and its owners or affiliated entities need to be at fair market value. The IRS may scrutinize arrangements that appear to shift income or expenses for tax advantages.
- Distributions — S-corps must ensure that shareholder-owners receiving distributions are also taking reasonable salaries. Underpaying wages can lead to payroll tax avoidance concerns.
- Changes in Ownership — The IRS may review whether changes in ownership, including new partners or capital contributions, are correctly reported and taxed.
- State and Local Compliance — Multi-state businesses face additional scrutiny, especially in states with pass-through entity taxes or withholding requirements for nonresident owners.
How to Reduce Audit Risk
While there is no guaranteed way to avoid an audit, businesses can take steps to minimize red flags and ensure compliance. Maintaining detailed and accurate records is key, particularly for income, expenses, allocations, and ownership changes. Well-documented financials make it easier to defend tax positions if an audit occurs.
Timely and accurate tax filings are another critical factor. Forms such as K-1s must be properly completed and submitted, and state/local tax requirements are equally important. Operating agreements and shareholder agreements should also be regularly updated to reflect how the business is run. This shows that income and loss allocations align with governing documents.
Distributions and compensation must also be carefully structured. Given the level of detail required for pass-through entities, working with a tax professional can help businesses navigate potential risks, particularly in areas like basis tracking and multi-state compliance.
Contact Us
Staying current on tax reporting requirements and maintaining clear financial records can help minimize audit risks. If you have questions about the information outlined above or need assistance with another tax or accounting issue, Wilson Lewis can help. For additional information call 770-476-1004 or click here to contact us. We look forward to speaking with you soon.
