A recent GAO report found that the IRS audits less than one percent of all large partnerships. The number of large partnerships, which is defined as partnerships with at least 100 direct or indirect partners and $100 million in assets, has increased by 47% from 2002 to 2011, while the number of C-Corporations has decreased by 33% over the same period. The report discovered that even with such an increase, in 2012 the IRS only audited .8 percent of large partnerships, while auditing 27 percent of large C-Corporations. And note that the Large Business and International Division at the IRS now has under its jurisdiction more flow through returns than it has C corporations.

The report, issued at the request of Senators McCain, Baucus, Wyden, and Levin, was focused on determining whether the IRS is adequately addressing concerns regarding the complexities created by large partnerships. While partnerships do not pay tax at the entity level, partners must pay income tax on the income received from the partnership. Large partnerships can have complex organizational structures with several tiers with hundreds of thousands of partners, resulting in administrative challenges for the IRS in tracing income through the different tiers to the ultimate partner. As a result of these complexities and the growing number of large partnerships, the GAO was asked to evaluate the IRS’s ability to audit such partnerships.

By analyzing documentation and data from 2002 to 2011 and interviewing key IRS audit personnel, the GAO discovered that while the number of large partnerships has more than tripled from 2002 to 2011, the IRS only audited .8 percent of all such partnerships in 2012. Further, most of these audits resulted in no change to the partnership’s return and only minor aggregate changes for all audited partners. This is most likely caused by the challenge of tracing income through multiple tiers of a partnership, while adhering to TEFRA time constraints. The IRS is also challenged by the fact that under current practice, it has traditionally tried to control each partner’s return for the statute of limitation. As you may guess, with the huge numbers of partners, this has proven nearly impossible.

Under TEFRA, which was enacted in 1982 to streamline the IRS’s audit of partnership returns, the IRS has three years to conduct an audit from the time the tax return is received, and then one year to assess adjustments. Because many of these partnerships have many partners, it can take months for the audit team to even identify the partner that represents the partnership in the audit, reducing the team’s time to conduct the audit. Additionally, because all adjustments must be passed to the applicable partners, the IRS must determine each partner’s share of the adjustment, a process which can be labor and time intensive. When adjustments must be made to a large number of partners in a partnership, the IRS must allocate great time and money to do so. This results in a limited number of audits of large partnerships the IRS is willing or able to conduct.

In an effort to address these issues, GAO reports that the IRS has initiated three projects to make the large partnership audit process smoother. One of the projects, the “Just-In-Time Linkage Pilot”, is still under development, while the other two projects, the “Large Partnership Compliance Management Team Pilot” and the “Large Partnership Procedures,” were found by GAO to have not been developed in line with project planning principles, which GAO argues will prevent the IRS from determining whether they actually improve efficiency. It should be noted that we have found that the IRS has recently begun to pick the partner returns it wishes to control and concentrate on rather than all the partners’ returns.

The GAO Report concluded that because of the complexities of tiered partnerships and the constraints imposed on the IRS by TEFRA, the IRS should 1) clearly define what constitutes a large partnership, 2) track audit results using revised audit codes, and 3) implement project planning principles for the audit procedure projects. Meanwhile, the Report recommended that Congress should amend TEFRA to require large partnerships to pay taxes on audit adjustments at the partnership level and to designate a qualified Tax Matters Partner to represent them during the audit. It appears that Congress and the Administration may be listening. In the last couple of Administration budget proposals; there has been a provision to lessen the burden on the IRS in auditing large partnerships. Chairman Camp’s tax reform proposal had a provision that would also change the way the IRS could audit these taxpayers by repealing TEFRA. Similarly, Senator Levin recently introduced legislation that would eliminate the impediments to large partnership audits by imposing a tax at the partnership level, rather than on the individual level. It remains to be seen what happens as tax reform is more widely considered.