GAO Issues Preliminary Report on Challenges in Auditing Large Partnerships

Posted by Mary McNulty and Lee Meyercord           The Government Accountability Office (“GAO”) recently issued a preliminary report on the challenges in auditing large partnership returns, a copy of which is available here.  The GAO issued an interim report earlier this year that addressed the number and characteristics of large partnerships and IRS audits of large partnership returns, which is discussed in a prior post.The GAO defines “large partnership” as a partnership that reported having 100 or more direct partners and $100 million or more in assets on its partnership income tax return.  Large partnerships are often structurally complex and involve more than 1,000 direct and indirect partners.  The IRS audits very few large partnership returns, and the audits result in minimal adjustments.  For example, in 2012, two-thirds of large partnership audits resulted in no changes to the partnership’s net income reported on the return, and the remaining one-third resulted in an average audit adjustment to partnership net income of $1.9 million. The report identified some challenges faced by the IRS in auditing large partnership returns that may explain the minimal adjustments to partnership net income.  Some of these challenges are due to administrative complexities in applying the TEFRA audit procedures to large partnerships.  These challenges include:The inability to identify the tax matters partner (TMP) of a large partnership in a timely manner, which reduces the time that the IRS can spend on substantive tax issues.The difficulty of passing through audit adjustments to the taxable partners in a large partnership structure.  In order to pass-through the adjustments, the IRS has to link the partners’ returns to the partnership return under audit, which can be a significant drain on IRS resources. The lack of timely support from TEFRA specialists on TEFRA audit procedures.In addition, complex tiered partnership structures make it difficult to identify tax noncompliance.  For example, IRS officials in focus groups said one challenge is determining which entity in a complex tiered structure is the source of income or losses within the structure. The IRS has taken steps to address the challenges in auditing large partnership returns.  One such effort is the use of closing agreements to collect tax from a net audit adjustment at the partnership level rather than passing through the adjustments to the taxable partners.  However, the report noted that the IRS cannot fully address the challenges in auditing large partnership returns because some of the challenges stem from complex tax laws, the TEFRA audit procedures, and constraints on IRS resources, which are out of the IRS’s control. The report is only a preliminary report on the challenges that the IRS faces in large partnership return audits and will contribute to a broader report expected out in the fall of 2014.  The fall report will offer a more in-depth analysis of the challenges and possible solutions.  These solutions may have implications for large partnerships and their partners and may foreshadow future legislation and an increase in the resources dedicated to auditing large partnerships.If you have any questions about large partnerships audits, please contact one of us or any of the other Tax lawyers at Thompson & Knight.