NEW YORK (AP) – The owners of what are called Subchapter S corporations might be feeling a little uneasy: This popular corporate entity has caught the eye of the IRS, which says it’s going to step up the number of audits it does on S corporations over the next couple of years.

The IRS plans to examine 5,000 randomly selected S corporation returns from the 2003 and 2004 tax years. The audits will start later this year, and should all be completed within two to three years.

Bruce Friedland, an IRS spokesman, said there’ll be no difference between these audits and any other audit of a business. The audited companies will have to show their records to IRS examiners, who will determine whether income and expenses were accurately reported and whether the correct amount of tax was paid.

What’s different, he said, is that the government will cull information from these audits to analyze how compliant companies are with tax law, and to decide whether any changes are needed in tax policy or the Internal Revenue Code.

“The people being examined really shouldn’t notice a difference,” Friedland said.

S corporations are attractive to shareholders because they offer the same liability as the more traditional C corporations without double taxation. While C corporations and their shareholders are each taxed, with S corporations, the company itself is not taxed and the income passes through to shareholders in much the same way as it does in a partnership. The shareholders are then taxed on their income on their individual 1040 returns. (The C and the S, by the way, refer to provisions in the tax code.)

S corporations are intended to be smaller companies. Through the 2004 tax year, there could be only 75 shareholders; starting with 2005, that number was lifted to 100, and all the members of a family can now count as a single shareholder. But the tax code also places restrictions on who can own an S corporation; shareholders must be U.S. citizens or resident aliens, and they must be people – other companies or partnerships cannot own shares in an S corporation.

There are many other regulations as well, and anyone contemplating or owning an S corporation should be consulting with a tax professional.

“They’re very complex, even for a small entity or small family business,” said accountant Jeffrey Berdahl, of the firm Beard Miller Co. in Allentown, Pa. “Their advisers should be sure they meet all the tests and that everything’s in line.”

Jeffrey Chazen, a tax partner at the accounting and consulting firm Richard A. Eisner & Co. LLP in New York, said the IRS is paying more attention to S corporations than it has in the past.

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

Chazen said the IRS has already been paying close attention to two aspects of S corporations and how they’re treated on company returns – the compensation of shareholders who are also employees, and the division of profits among the owners.

With compensation, the IRS is looking to see whether employee shareholders are forgoing a salary or reporting artificially low pay in favor of a big dividend. Chazen noted that some shareholders have done so to reduce or even eliminate self-employment taxes; that’s against the law.

Berdahl said, “There’s not a black and white distinction of what’s reasonable and unreasonable, but that’s an area that could be attacked” in an audit.

With the division of profits, the tax code calls for an S corporation’s earnings to be distributed according to the shareholder’s stake – if there are two owners, for example, each should receive 50 percent of the profits. But in some companies, as in partnerships, the owners might want to divide the profits 60-40, or by some other percentage breakdown; that’s OK in a partnership, but illegal in an S corporation.

Another problem an S corporation might run into during an audit concerns health insurance, Chazen said. Unlike a C corporation, S corporations cannot take deductions for employee shareholders’ health insurance; they need to deduct it themselves on their 1040s.

Another caveat: If your company isn’t already an S corporation, you can’t just switch. Owners need to make their election to be a Subchapter S corporation at the time the company is started.

But Chazen said that despite the popularity of S corporations, “their best years are probably behind them” as more business owners choose the limited liability company as a business entity. With an LLC, “you have the liability protection with the flexibility of being a partnership,” he said.