By Remy Welling

If you own a closely held corporation, you may wonder how the Internal Revenue Service selects corporate returns for audit.

If you are requesting a large refund, your return may be tantamount to an invitation for an audit. Congress’ Joint Committee on Taxation must review all refunds over a prescribed amount, arising from net operating loss carrybacks and credit carrybacks. In 2005, the prescribed amount was $2 million. Agents are required to contact such corporations and request information to verify the accuracy of the refund, as well as its origin.

What else could render your corporate return more audit worthy? Agents inspect the return’s Balance Sheet, Schedule M-1 and Schedule M-2 in an effort to choose returns with the highest audit potential.

Just as the eyes are the window to the soul, so balance sheets are the window to the business enterprise.

On the balance sheet, agents look for line items such as “loans to shareholders” to try to recharacterize owners’ personal expenses as “constructive dividends,” in accordance with the courts’ established guidelines.

Constructive or disguised dividends are, in essence, a penalty. Such expenses are disallowed to the corporation and must be included on the owners’ individual returns as income.

Fortunately, the recent reduction in the tax rate on dividends (including constructive dividends) to 15 percent lessens the impact of this penalty. But be aware that these lower tax rates on dividends are subject to a sunset provision due to expire after 2008.

After the balance sheet, agents look to the Schedule M-1 to determine audit potential. The Schedule M-1 reconciles your books to your tax return by specifying those items of income and expense on your books that differ from those on your corporate tax return.

Agents check for Schedule M-1 line items such as travel and entertainment expenses, which are fully deductible for book but only partially deductible for tax purposes. The absence of such Schedule M-1 line items could trigger an audit.

Since the goal of maximizing profits on the books to obtain additional capital or loans is often at odds with the goal of minimizing the corporation’s federal income tax liability, the presence of Schedule M-1 line items such as “tax-exempt” or “tax-deferred” income could also be a red flag.

After Schedule M-1, agents turn their focus to Schedule M-2 line items, which include current-year changes to earnings from all prior years. Agents check for the presence of line items such as corrections to prior years’ earnings, also referred to as “prior period adjustments,” lest revisions to taxable income require adjustment.

Understand your audit potential. Consult with your tax professional for the best approach.

Remy Welling holds a master’s degree in professional accounting from the University of Texas at Austin and was employed as an IRS field agent for more than 22 years. E-mail questions or suggestions to remywelling@sbcglobal.net.