New IRS Unit Begins Targeting Pass-Through Businesses

The agency says the initiative will ‘increase fairness’ in its enforcement activities.

People walking near the IRS building in Washington on Jan. 4, 2024. Madalina Vasiliu/The Epoch Times

The IRS has officially launched a new unit that it states will “more efficiently conduct audits” of entities known as pass-through businesses.

The initiative targets businesses that pay no taxes on their revenue. Instead, the income generated is passed on to owners who then file taxes based on their individual taxation rates. Pass-through businesses include sole proprietorships, partnerships, limited liability companies, and S-corporations.

In September, the IRS stated that it is establishing a unit within the agency’s Large Business and International (LB&I) division focusing on large or complex pass-through entities.

On Oct. 22, the agency announced that the unit “has officially started work.”

The new department will seek to ensure compliance from pass-through entities of every size and form, including S-corporations, partnerships, and trusts. The agency stated that these businesses are being used to evade taxes.

“The establishment of pass-through field operations is a significant step in our goal to increase fairness in enforcement while improving service,” IRS Commissioner Danny Werfel said.

“By using Inflation Reduction Act funding and enhancing our expertise in this area, we will be able to reverse our historically low audit rates for complex arrangements employed by certain high-wealth individuals and large entities.”

Pass-through examinations had been divided between two IRS divisions—LB&I and the Small Business/Self-Employed. The cases were assigned on the basis of entity size.

Revenue agents from the new pass-through unit will be grouped into teams based on geography. They will be tasked with primary examination of returns related to pass-through businesses.

While the IRS claims that funds from the Inflation Reduction Act will be used to go after high-income groups, it earlier admitted that lower-income groups could be targeted if there was a funding crunch.

In such a situation, the agency will be forced to cut down enforcement staff by more than 50 percent in fiscal year 2030, the IRS stated in May. This would “severely” affect the agency’s ability to carry out complex audits.

“Since lower-income taxpayers are more likely to have simple tax returns, this lack of funding will likely translate into a higher share of audits falling on low- and middle-income taxpayers, while examination coverage rates for high-income and large corporate taxpayers will severely decline,” the agency stated.

Pass-Through Deductions

The IRS unit targeting pass-through entities has been set up just as a key tax deduction available to these businesses has come under threat.

In 2017, President Donald Trump signed into law certain tax cuts, including a provision that allows pass-through entity owners to deduct 20 percent of their qualified business income when calculating taxes. The law is set to end in 2025.

That deduction has generated some criticism. A report by the left-leaning Center for American Progress concluded that the measure has “disproportionately benefited the wealthy and has encouraged businesses to game the tax code to maximize qualifying income.”

More than half of all pass-through deductions in 2021 were claimed by tax filers with adjusted gross incomes (AGI) of $500,000 or more, according to the report.

“Moreover, wealthy filers claimed substantially larger average deductions—$1,024,246 for those with AGI of $10 million or more. By contrast, filers with AGI below $100,000 with the deduction—who accounted for 51 percent of claimants—claimed, on average, $1,997,” the organization stated.

The U.S. Chamber of Commerce is arguing for retaining the tax deduction. It points out that Congress permanently reduced the tax rate on corporate income from 35 percent to 21 percent in 2017, according to a Feb. 14 statement.

The 20 percent deduction for pass-through entities was enacted to ensure that these businesses “weren’t put at a tax disadvantage” against corporations, the chamber stated.

Making this deduction available only to business owners with less than $500,000 in annual income will “result in a tax increase on one of the major sources of jobs in our nation, directly hurting workers and the economy,” it stated.

The chamber urged Congress to make the 20 percent deduction permanent for pass-throughs.