The Internal Revenue Service announced on Monday, July 25, that it will randomly audit 5,000 tax returns of S corporations to study overall tax compliance of these popular corporate entities.

The IRS will look at tax years 2003 and 2004. Examiners will determine whether income and expenses were accurately reported and whether the correct tax was paid, just like any other audit. The audits will start later this year and should be complete within two or three years.

The IRS will take the information and use it to analyze overall compliance and to see whether tax changes are needed.

"For those companies that happen to win this lottery, this will be a real thorn in their side," said attorney Richard Colombik of Tax Law Solutions based in Schaumburg, Ill. "Statistical audits tend to be much more in depth: They take more time to collect the data, and for those companies that choose to hire representation, they probably will be more costly," he told Inc.com. But IRS spokesman Bruce Friedland said, “The audits in this study will be very similar to a standard exam, neither more or less intensive."

He added, "The focus of this study has more to do with compliance and eliminating the confusion corporations may have in filing returns; the IRS isn't using this study as a means to uncover willful tax evasion.”

Numerous restrictions and requirements apply to S corporations, and the rules can be confusing. According to the Associated Press, S corporations are smaller companies that enjoy the same liability as the more traditional C corporations, but with less tax. C corporations and their shareholders are each taxed, but with S corporations the company is not taxed and the income passes to the shareholders as it does in a partnership. The shareholders are then taxed on their income on 1040s.

Jeffrey Chazen, a tax partner at the accounting and consulting firm Richard A. Eisner & Co. LLP in New York, told the AP that the IRS is starting to pay more attention to S corporations.

"Historically your risk of audit has been less, and I think the IRS now understands that," he said.

Chazen said the IRS is scrutinizing two aspects of how S corporations are treated on company returns - the compensation of shareholders who are also employees, and the division of profits among the owners.

The last compliance study of S corporations goes back to 1984, prior to the tax law changes that sparked their growth. The number of S corporations has risen from 724,749 in 1985 to 3,154,377 in 2002, the IRS said.