Most tax audits of big partnerships proved fruitless

Over three-quarters of the audits conducted by the Internal Revenue Service under its centralized partnership audit regime resulted in no change in taxes, according to a new report.

The report, released Wednesday by the Treasury Inspector General for Tax Administration, examined the impact of a provision of the Bipartisan Budget Act of 2015 that allowed the IRS to streamline the audits of large partnerships such as private equity firms, hedge funds, venture capital firms and major accounting firms by auditing the partnership as a whole, instead of each individual partner. The rules and regulations were widely contested for years by the private equity and hedge fund industry, which had long been accused of avoiding taxes under the earlier rules. In fiscal year 2018 the IRS began examining the initial set of partnerships that had actually opted to be part of the new centralized regime. However, among that relatively small set of partnerships, TIGTA found the audits usually led to no change in the taxes they owed.

A review of the initial examination efforts under the centralized partnership audit regime rules found that as of the end of fiscal year 2021, the IRS had completed a total of 480 examinations of returns filed for tax years 2016 through 2019. The IRS closed 376 of the partnership returns (or approximately 78%) as a no-change. That rate was relatively high compared to the average no-change rate of 50% for all partnership returns for the same tax years that were closed as of Sept. 30, 2020.

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However, while IRS management agreed with TIGTA that the no-change rate was high, it believes it’s too early in the process to analyze and form conclusions about the no-change rate. But the IRS also acknowledged that it has not decided on what acceptable rates or ranges would be used to measure closure types for examinations. The IRS doesn’t establish goals based on audit procedures such as the centralized partnership audit regime.

“However, the centralized partnership audit regime provides a centralized method of examining items of a partnership that should limit the burden on the IRS in both the examination and judiciary process,” said TIGTA. “Therefore, the IRS should measure whether partnership examinations performed after the centralized partnership audit regime was in place are taking less overall resources to complete and administer in comparison to pre-centralized partnership audit regime results. By not having these targets, the IRS cannot measure the effectiveness of the new audit rules on taxpayer compliance.”

When a partnership has imputed underpayments due to an examination under the centralized partnership audit regime, a partnership representative can ask to modify the amount or push it out to partners. While the IRS has developed a manual compliance monitoring process to confirm adjustments to partners’ returns when a partnership makes a push-out election, the process isn’t fully systemic, TIGTA found. But without a proper systemic monitoring process, TIGTA noted, the underreporting or nonreporting of adjustments may only be detected through a cumbersome time intensive manual process.

TIGTA recommended the IRS address the centralized partnership audit regime examination no-change rates, establish goals and measures that address the expected outcomes from the implementation of the centralized partnership audit regime, and implement a fully systemic method to monitor and verify push-outs are properly reported on partners’ returns. The IRS agreed with TIGTA’s final recommendation and intends to work on developing a systemic way to verify push-outs. However, the IRS disagreed with the report’s other two recommendations, though TIGTA said it believes the recommendations would help the IRS address the factors contributing to the high no-change rates.

The IRS objected to the TIGTA report zeroing on the centralized partnership audit regime instead of the wider implementation of the Bipartisan Budget Act as originally planned and noted that it was still in the early stages of developing its approach to auditing partnerships under the new regime.

“The IRS is aware that there is significant progress to make in this area,” wrote Nikole Flax, commissioner of the IRS’s Large Business and International Division, in response to the report. “Indeed, it is because we are in the early stages of several partnership related efforts that we understood TIGTA agreed to postpone a separate audit on efforts to identify and audit high risk partnership issues as it would have been a premature considering the status of our recently launched Large Partnership Compliance (LPC) program and other initiatives.”

To support its efforts, the IRS has been hiring subject-matter experts and field agents who will specialize in large partnership audits and it has begun to improve its forms and case selection models. “Progress from these efforts will take some time to realize,” Flax added. “The IRS’s increased focus on high income individuals, and the entities they control, is another compliance touch point that will increase enforcement coverage of partnerships.”