For years, many business owners and many of their advisors have assumed that the IRS focuses its enforcement resources on giant C-corporations or ultra-wealthy individuals. In reality, pass-through entities—including S-corporations, partnerships, LLCs, trusts, and sole proprietorships—are squarely in the IRS’s crosshairs. Recently, the IRS has made an intensified effort to audit and, where appropriate, criminally investigate pass-throughs of every size and form, citing concerns about intentionally unreported income, fraudulently inflated deductions, and other forms of willful tax evasion. The agency has even established a new pass-through field operations unit—operational since late 2024—to accelerate these tax audits and “reverse long-term compliance declines.”
Taxes for pass-through entities have long been challenging to navigate, and the changes brought about by the Tax Cuts and Jobs Act and the new operation units have only amplified this complexity. At the Tax Law Offices of David W. Klasing, our dual-licensed criminal tax defense attorneys & CPAs routinely encounter pass-through owners blindsided by high-risk audits that can morph into criminal tax probes. With the IRS now devoting substantial new resources—and advanced analytics—to this arena, anyone filing pass-through income should be vigilant. If you face or fear a pass-through audit, immediate strategic action may safeguard not only your assets but also your liberty. We can help ensure your business complies with all regulations while maximizing every deduction available to you. Call us today at (888) 640-3408 or contact us online HERE to set up a reduced-rate initial consultation.
Why the IRS Is Intensifying Its Pass-Through Entity Auditing
A Surge in Enforcement Resources
Historically, the IRS’s pass-through audit rate fell dramatically—from 3.8% in 2010 to 0.1% in 2019—primarily due to budget constraints. That landscape has changed. Funding from the Inflation Reduction Act, along with an internal hiring initiative that’s added more than 3,700 enforcement positions, has given the IRS renewed bandwidth to target potential tax noncompliance among partnerships, S-corps, LLCs, and sole proprietorships.
Formation of a Specialized Pass-Through Field Operations Unit
In September 2023, the IRS officially announced plans to create a dedicated pass-through team within its Large Business and International (LBI) Division. By October 2024, this new unit was already examining pass-throughs of “every size and form.” Building on prior declarations by IRS Commissioner Danny Werfel, the agency’s stated aim is to increase oversight of high-income individuals and the often-complex structures they use—while making it clear that smaller pass-throughs are also subject to scrutiny.
Ongoing Campaigns and Future Outlook
The IRS is determined to clamp down on perceived abuses, including so-called “sophisticated tax-free transactions” and complex arrangements that mask actual beneficial ownership or artificially reduce reported income. Officials have repeatedly underscored that this crackdown seeks to “stop partnerships and other pass-throughs from hiding behind complexity to avoid paying taxes.”
Meanwhile, compliance letters and tax audits are already targeting over 75 of the country’s largest partnerships, plus 500 additional pass-through entities—signaling the agency’s seriousness in reversing the decline in high-income audits.
Pass-Through Entities: Why They’re Common—But Susceptible to High-Risk Tax Audit
What Is a Pass-Through Entity?
- S Corporations – Income, losses, credits, and deductions pass through to shareholders, avoiding the “double taxation” that typically applies to C corporations.
- LLCs – Limited liability companies default to partnership treatment for federal tax purposes unless they elect S-corp or C-corp status. Single-member LLCs default to sole-proprietor reporting (Schedule C).
- Partnerships – Not subject to corporate income tax; instead, partners report their shares of income or loss on personal returns.
- Sole Proprietorships – Operated by an individual who pays tax on business income at personal rates.
Why So Many Pass-Throughs?
These structures avoid corporate-level tax—only owners pay at the individual level. Owners may also circumvent certain SALT (state and local tax) deduction limits and, in many situations, claim the Section 199A pass-through deduction. As a result, pass-through filings have soared, particularly among higher-asset businesses; the IRS noted a 70% jump in filings from larger pass-throughs (over $10 million in assets) between 2010 and 2019.
Potential for Noncompliance
Because pass-through income flows directly to personal returns, the IRS suspects many owners underreport receipts or inflate deductions. Entities that fail to issue correct K-1s or that blur personal, and business expenditures frequently trigger high-risk tax audits. The new pass-through field operations unit is designed to identify such “high-risk” returns more efficiently.
Who Is Impacted?
The IRS’s renewed focus on pass-throughs has a broad reach:
- High-Income Earners – According to the Tax Policy Center, for the 2022 tax year, over 90% of net pass-through income was reported by those in the top 20% of earners, with more than half reported by the top 1%. These individuals are prime targets.
- All Pass-Through Entity Sizes – While the emphasis is often on large or complex partnerships and S-corporations, the IRS stresses it will audit pass-throughs “of every size and form.” Even modest sole proprietorships or single-member LLCs are not automatically safe.
- Employers of a Big Segment of the Workforce – Pass-through entities historically employ around 43% of U.S. workers. The IRS’s push could affect millions of small-business owners, staff, and stakeholders.
If you have substantial income, sophisticated tax planning structures, or undisclosed foreign accounts, you may be in the crosshairs. Seek support and guidance from our Dual-Licensed Tax Lawyers & CPAs by calling the Tax Law Offices of David W. Klasing at (888) 904-4096 or clicking here to schedule a reduced rate initial consultation. If you are willing to knock on the IRS’s door before they bang down yours, we can secure a pass on criminal tax prosecution even where you blatantly cheated for decades.
Common Red Flags for Pass-Through Audits & Investigations
Excessive Schedule E Losses
Chronic or substantial losses may indicate a disguised hobby or personal spending rather than a bona fide profit motive.
Minimal or Zero W-2 Wages in S-Corps
Owners paying themselves in “distributions” alone can draw intense scrutiny, with the IRS often reclassifying these as wages.
Erratic or Special K-1 Allocations
Sudden changes in how profits or losses are split among partners may arouse suspicion if there is lack of a clear business rationale.
Omission or Delayed Issuance of K-1s
Failing to issue K-1s or misreporting partner information can unravel a host of noncompliance issues.
Inflated Business Deductions
Combining personal expenses with legitimate business costs—especially regarding vehicles, travel, or home office usage—is a perennial red flag.
Potential Civil and Criminal Tax Exposure
Civil Penalties Under IRC § 6662 or § 6663
When a tax audit uncovers substantial understatements of income or overstatements of deductions, the IRS may impose a 20% accuracy-related penalty. If agents conclude you acted with fraudulent intent, that penalty can spike to 75% of the underpayment.
However, it’s important to note, if the IRS has the evidence necessary to assert the 75% civil fraud penalty, they have the evidence to criminally convict.
Criminal Tax Charges Under IRC § 7201, § 7206, and Related Statutes
Willful tax evasion—through falsified returns, “cooked books,” or concealed offshore ownership—opens the door to felony tax charges. Conviction can mean steep fines, restitution, and multi-year prison terms. The IRS’s new pass-through unit will be especially vigilant in identifying “willful noncompliance,” citing “complex tax arrangements” that lack economic substance.
Routine exams can become criminal tax inquiries if revenue agents suspect fraud. In an eggshell audit, the taxpayer knows incriminating details that are not yet fully apparent to the IRS. Conversely, in a reverse eggshell audit, the IRS covertly builds a criminal case while you believe it’s still “routine.” Suppose you have failed to file a tax return for one or more years or have taken a position on a tax return that could not be supported by an IRS or state tax authority audit, eggshell audit, reverse eggshell audit, or criminal tax investigation. In that case, it is in your best interest to contact an experienced tax defense attorney to determine your best route back into federal or state tax compliance without facing criminal prosecution.
As long as a taxpayer that has willfully committed tax crimes (potentially including non-filed foreign information returns coupled with affirmative evasion of U.S. income tax on offshore income) self-reports the tax fraud (including a pattern of non-filed returns) through a domestic or offshore voluntary disclosure before the IRS has started an audit or criminal tax investigation/prosecution, the taxpayer can ordinarily be successfully brought back into tax compliance and receive a nearly guaranteed pass on criminal tax prosecution and simultaneously often receive a break on the civil penalties that would otherwise apply.
How the IRS Uncovers Pass-Through Tax Evasion
- Financial Data Analysis – Algorithms and data mining compare reported income and expenses against third-party records.
- Third-Party Reporting – Banks, payment processors, and employers issue 1099s and W-2s that the IRS cross-references with returns.
- Whistleblower Tips – Informants can alert the IRS to hidden income streams or contrived losses.
- Data Sharing & AI – Domestic and international cooperation, coupled with advanced technology, reveals complex layering or offshore transactions.
- Audits & Examinations – Triggered by red flags, leads, or random selection. Agents can escalate from civil audits to criminal referrals if they suspect willfulness.
- Public Records & Open Source Intelligence – Investigators scour court filings, social media, real estate records, and more to spot undisclosed assets or income.
What Actions Should Pass-Through Owners Take—and When?
The IRS’s new teams have been operational since late 2024, with complex partnership audits already underway. Meanwhile, compliance letters are being sent to numerous pass-through entities—some of which are mere preludes to a full-blown tax audit. It would be wise to:
Assess Your Recent Tax Filings
Confirm your entity’s returns—and your personal returns—correctly account for all income, deductions, and distributions over the last several years.
Remediate Potential Issues Proactively
Depending on your circumstances, remedial action could involve filing amended returns or engaging in a domestic/offshore voluntary disclosure. Carefully weigh the pros and cons; rash or ill-conceived measures can backfire badly.
Maintain Audit-Ready Documentation
Should the IRS or state tax authorities send a compliance letter, you want robust records readily available to address any discrepancies.
Consider Formal Legal Representation
If you receive direct IRS inquiries—or suspect they’re imminent—speak with dual-licensed attorney-CPAs well versed in civil and criminal tax controversies. This ensures attorney-client privilege and Work Product Privileges with the possibility of a Kovel agreement if forensic CPAs need to be consulted.
Contact the Tax Law Offices of David W. Klasing if You Are Worried About Pass-Through Entity Noncompliance
At the Tax Law Offices of David W. Klasing, our skilled Tax Attorneys and CPAs have a long track record of assisting individuals and businesses that operate as pass‑through entities—from sole proprietorships and single‑member LLCs to complex multi‑tier partnerships and S corporations. We thoroughly review each client’s specific structure, legal agreements, and transactional history to identify tax risks and opportunities alike. Drawing on extensive experience in both the accounting and legal spheres, we can help clarify how evolving federal and state laws apply to your pass‑through’s unique operations.
Whether you are grappling with questions about correctly reporting Schedule E income, ensuring that W‑2 wages and shareholder distributions in your S corporation are set to reasonable standards, or navigating complicated partnership basis and allocation rules, our dual‑licensed team can deliver insights based on decades of hands‑on practice. We help uncover deductions and credits you might otherwise overlook while steering you clear of missteps that could trigger civil tax penalties or, in the worst scenarios, criminal tax prosecution. By investing the time to understand each client’s goals, challenges, and concerns, we enable pass‑through owners to operate with clarity and confidence—even in a rapidly shifting tax environment. To set up a reduced rate initial consultation, contact us today at (888) 640-3408 or online HERE.
