The 1120-S audit rate is near zero, and that is not the point

That is also not the reason to relax. The audit rate is a population statistic; a filer is not a random sample of the population, and the IRS knows it.

How the number got this small

The Service has been shrinking. Appropriations have fallen every year since fiscal 2010 in nominal dollars, and more than that in real terms. The enforcement workforce — revenue agents, tax compliance officers, and revenue officers — is down by roughly a quarter from its 2010 peak. The fiscal 2015 Data Book, released this spring, showed the overall individual audit rate at about 0.8 percent, the lowest in more than a decade. Business returns moved in the same direction.

Pass-through entities moved further. S-corp examinations have been in the 0.3-to-0.4 percent range for several years; partnership exams are lower still, in the 0.4 percent neighborhood, which is remarkable given the explosion in partnership filings over the last decade. C-corporation audit rates remain higher, concentrated at the largest balance-sheet tiers, where the Service still staffs coordinated-industry-style work on the biggest filers. Everywhere below those tiers, the rate has been bleeding out.

Part of this is arithmetic: the denominator keeps growing. There were roughly 4.5 million S-corp returns filed for tax year 2014, up from about 4.2 million three years earlier. Examinations would have to rise just to hold the rate flat, and they have not.

Part of it is the shape of the work. A 1120-S is harder to audit than it looks. The return itself is short; the exam is not. A thorough S-corp examination means pulling the shareholder's 1040, reconciling the K-1, testing reasonable compensation, chasing basis, and — increasingly — deciding whether to follow distributions into a second-tier entity. Revenue agents who can work these cases are the same agents the Service leans on for partnerships and complex individuals. They are scarce, and their time is rationed.

And part of it is policy drift. Congress spent the last several years asking the IRS to administer the Affordable Care Act's premium tax credit, stand up identity-theft controls, and prepare for the partnership audit overhaul in the Bipartisan Budget Act of 2015. Each of those has pulled staff away from field exams of smaller entities. None of them has come with the budget to backfill.

What the low rate actually means for a filer

It does not mean the 1120-S is a free square. It means the exam population has gotten more concentrated, not more lenient.

Two mechanisms catch S-corps without a field audit and both are working harder, not less, than the headline rate suggests.

The first is document matching. The IRS's information-returns program reconciles 1099s, W-2s, and K-1s against what taxpayers report. This is cheap, automated, and it has been getting better. An S-corp that issues 1099-MISCs sloppily, or whose shareholder omits a K-1 amount on the 1040, will hear about it through a CP2000 notice rather than a field exam — and the notice does not show up in the audit statistics at all.

The second is reasonable compensation. This remains the single most reliable way for a small S-corp to draw a second look. A sole shareholder-officer who runs $400,000 of profit through the entity and takes $30,000 of W-2 wages is flagged not by a human but by a scoring model, and then sorted into a workflow whose output, some fraction of the time, is a correspondence exam or a field visit. The Service's position on the issue has not softened since the Watson decision in the Eighth Circuit, which upheld a recharacterization of distributions as wages. Examiners cite it routinely.

The returns that do get pulled for field exam are, increasingly, the ones the Discriminant Inventory Function scored high: unusual compensation ratios, large losses against limited basis, loans to shareholders that look like disguised distributions, travel and meals out of proportion to revenue, home-office deductions inside an S-corp structure, and the occasional entity that files consistently at or near zero while supporting a visible lifestyle. The exam population is smaller. It is not softer.

The reforms that are coming, and the ones that are not

The partnership audit rules are about to change. The Bipartisan Budget Act of 2015 repealed TEFRA and replaced it with a centralized regime under which, beginning with tax years starting in 2018, the IRS can assess and collect partnership adjustments at the entity level rather than chasing each partner individually. Large partnerships will be able to elect out only in narrow cases. The practical effect is that the Service expects to recover lost ground on partnership exams by making each exam cheaper to conclude, not by running more of them.

No such reform is pending for S-corporations. The 1120-S regime stays where it has been: adjustments flow through to shareholders, each shareholder is a separate collection problem, and the statute of limitations runs off the individual return. That is part of why S-corp exams cost what they cost, and part of why the Service has, over time, preferred to chase the same revenue through 1099 matching and compensation challenges instead.

Treasury has signaled interest in built-in-gains holding periods and in tightening the rules on self-employment tax for certain pass-through income, but neither has produced a regulation a filer needs to plan around in June 2016. What is not yet clear is whether a future Congress extends something like the BBA 2015 architecture to S-corps. If it does, the audit math for this entity changes quickly.

How a careful filer should think about exam risk

The right posture is not "the rate is 0.3 percent, so I am fine." It is closer to: the random component of audit risk has collapsed, and the non-random component has not. A filer whose return looks ordinary — wages in a defensible range, K-1s that tie to the 1040, 1099s issued where required, distributions that are not loans in disguise — is running a vanishingly small exam risk and a nontrivial CP2000 risk, which can be managed by tightening information-return hygiene.

A filer whose return is scored by DIF as an outlier is running an exam risk that has barely moved, because the agents who work those cases are still there and the cases they work have always been the ones that scored high.

The useful lesson from the 2015 Data Book is not that the IRS has gone away. It is that the agency is auditing at the margin with a much sharper pencil. The returns that get pulled are the ones that earned the attention. If you are preparing 1120-S returns for a living, the practical change is not to tell clients they are safe. It is to spend the extra fifteen minutes per engagement on the two or three line items that score.