Large Partnerships: Growing Population and Complexity Hinder Effective IRS Audits
Published: 2014-07-22T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Businesses organized as partnerships have increased in number in recent years while the number of C corporations (i.e. those subject to the corporate income tax) has decreased. The partnership population includes large partnerships (those GAO defined as having $100 million or more in assets and 100 or more direct and indirect partners). Their structure varies. Some large partnerships have direct partners that are partnerships and may bring many of their own partners into the structure. By tiering partnerships in this manner, very complex structures can be created with hundreds of thousands of direct and indirect partners. Tiered large partnerships are challenging for the Internal Revenue Service (IRS) to audit because of the difficulty of tracing income from its source through the tiers to the ultimate partners.
GAO was asked to study the challenges large partnerships pose for IRS. GAO describes the number of large partnerships and their assets, IRS's large partnership audit results and the challenges IRS faces in auditing these entities, and options for addressing these challenges. GAO analyzed IRS data on partnerships, reviewed IRS documentation, interviewed IRS officials, met with IRS auditors in six focus groups, and interviewed private sector lawyers knowledgeable about partnerships.
section_title: What GAO Found
paragraphs: Internal Revenue Service (IRS) data show, from tax years 2002 to 2011, the number of large partnerships more than tripled. According to IRS officials, many large partnerships are hedge funds or other investment funds where the investors are legally considered partners. Many others are large because they are tiered and include investment funds as indirect partners somewhere in a tiered structure. According to IRS data, there were more than 10,000 large partnerships in 2011. A majority had more than 1,000 direct and indirect partners although hundreds had more than 100,000. A majority also had six or more tiers.
IRS audits few large partnerships—0.8 percent in fiscal year 2012 compared to 27.1 percent for large corporations. Of the audits that were done, about two-thirds resulted in no change to the partnership's reported net income. The remaining one-third resulted in an average audit adjustment to net income of $1.9 million. These minimal audit results may be due to challenges hindering IRS's ability to effectively audit large partnerships. Challenges included administrative tasks required by the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) and the complexity of large partnership structures due to tiering and the large number of partners. For example, IRS auditors said that it can sometimes take months to identify the person who represents the partnership in the audit, as required by TEFRA, reducing the time available to conduct the audit. Complex large partnerships also make it difficult to pass through audit adjustments across tiers to the taxable partners.
IRS cannot resolve some of the challenges because they are rooted in tax law, such as those required by TEFRA. Congress and the Administration have proposed statutory changes to the audit procedures for partnerships, such as requiring partnerships to pay taxes on net audit adjustments rather than passing them through to the taxable partners. In addition, IRS has implemented some changes to its large partnership audit process, such as understanding the complexity of large partnerships and selecting returns for audits.
section_title: What GAO Recommends
paragraphs: GAO makes no recommendations but will issue a report later in 2014 assessing IRS's large partnership audit challenges. IRS provided technical comments, which were incorporated.

section_title: Letter
paragraphs: I am pleased to be here today to discuss the growing number and  complexity of large business partnerships—those with 100 or more direct  and indirect partners and $100 million or more in assets. I will also  discuss the Internal Revenue Service’s (IRS) large partnership audit  results as well as the challenges IRS faces in auditing these entities, and  options for addressing these challenges.
Partnerships are pass-through entities that generally do not pay taxes  themselves on income (unlike C corporations which pay corporate income  tax), but instead, pass income or losses through to their partners, who  must include that income or loss on their income tax returns. Large  partnerships can have very complex structures. Since partnerships may  be partners in other partnerships, their structures may include tiers or  levels of partnerships. Some have dozens of tiers with hundreds of  thousands of direct and indirect partners (partners in a lower-tier  partnership are indirect partners in higher tiers). Businesses may have  legitimate reasons to set up such tiered networks, such as isolating one  part of a business from liabilities or losses of another part. However,  partnership networks can also be used to evade taxes. IRS faces the  daunting task of verifying that income is properly reported for tax  purposes as it passes through the tiers and is ultimately distributed to the  direct or indirect partners responsible for making tax payments.
My testimony today builds on a body of work on large partnerships,  including an interim report we issued in March 2014 as well as a recently  issued report on all partnerships. We are doing broader, ongoing work on  large partnerships and plan to issue a report in fall 2014 but will discuss  some preliminary findings today. The fall report will provide a more in- depth analysis of IRS data on large partnerships, IRS’s audit challenges,  and the potential steps to mitigate them.
There is no statutory, IRS, or industry-accepted definition of a large  partnership. Throughout this statement, we define a large partnership as  having 100 or more direct and indirect partners and $100 million or more  in assets. This definition is consistent with how IRS identifies certain  partnerships based on the number of partners and asset size.
A partnership has become the tax entity of choice for many businesses in  recent years. IRS’s strategic plan for 2014-2017 notes that businesses  with U.S. tax obligations are increasingly adopting more complex  structures, shifting away from C corporations and moving towards pass- through entities, such as partnerships. Between tax years 2002 and 2010,  the number of businesses organized as a partnership rose 45 percent  from about 2.2 million to 3.2 million. In contrast, the number of C  corporations decreased about 14 percent from 1.9 million to 1.6 million  over the same time period.
Because of tiering, measuring the number of unique partners, the assets,  and the income of a large partnership is complicated. For example, in  figure 1, partnership B has three direct individual partners, and  partnership C has two. Partnerships B and C are direct partners in  partnership A, which also gives A five indirect partners of which four are  unique. Adding up the income (or assets) of partnerships A, B, and C  would result in double counting of income among the partnerships  because income from partnership A is divided between partnerships B  and C as it passes through to these unique partners.
If a separate large partnership, call it D, with 1,000 partners, were to buy  partnership C’s ownership interest in A, then partnership A would itself  become a large partnership. It would then have two direct partners and  1,003 indirect partners.
We analyzed data on the number and characteristics of large  partnerships and what IRS knows about the cost and results of audits of  large partnership returns. We reviewed IRS documentation and our  recent reports on partnerships. Finally, we interviewed a number of IRS  officials, held six focus groups with IRS auditors that had worked on  audits of large partnerships, and interviewed private sector lawyers  knowledgeable about partnerships. The results of the analyses of focus  group data are not generalizable to all IRS audits and do not necessarily  represent the official viewpoint of IRS. Instead the results were used to  identify themes in conjunction with the other forms of data we analyzed.  To determine data reliability, we reviewed relevant documentation,  interviewed knowledgeable IRS officials, and electronically tested the  data to identify obvious errors or outliers. We determined that the data  were sufficiently reliable for the purposes of this report. Our prior reports  include a detailed description of our scope and methodology.
Our prior reports and ongoing work was conducted in accordance with  generally accepted government auditing standards. Those standards  require that we plan and perform the audit to obtain sufficient, appropriate  evidence to provide a reasonable basis for our findings and conclusions  based on our audit objectives. We believe that the evidence obtained  provides a reasonable basis for our findings and conclusions based on  our audit objectives.
subsections: section_title: Large Partnerships Have Grown in Number, Size, and Complexity Since 2002 with Hundreds Now Having More Than 100,000 Partners
paragraphs: According to IRS data, between tax years 2002 to 2011, the number of  large partnerships more than tripled from 2,832 to 10,099. Over the same  time, total assets of large partnerships more than tripled to $7.49 trillion.  However, these numbers suffer from the double-counting complexities  illustrated in figure 1. For comparison, our interim report on large  partnerships, which defined large partnerships as those with 100 or more  direct partners and $100 million or more in assets, found that over the  same time period the number of large partnerships more than tripled,  from 720 in tax year 2002 to 2,226 in tax year 2011. Similarly, total assets  tripled to $2.3 trillion in tax year 2011.
Without an accepted definition of a large partnership, there is not  necessarily a right or wrong answer of whether direct and indirect  partners should be included. Direct partners do not capture the entire size  and complexity of large partnership structures. Accounting for indirect  partners does, but it also raises the issue of double counting discussed  above. Given the size and complexity of large partnerships, IRS does not  know the extent of double counting among this population.
Large partnerships, especially those in higher asset brackets, are  primarily involved in the finance and insurance sector. For example, in  2011, 73 percent of large partnerships reported being involved in the  finance and insurance sector and the majority of large partnerships that  reported $1 billion or more in assets were in this sector. IRS data also  showed that almost 50 percent of large partnerships with 100,000 or more  direct and indirect partners reported being in the finance and insurance  sector.
According to IRS officials and data, many of these entities are investment  funds, such as hedge funds and private equity funds, which are pools of  assets shared by investors that are counted legally as partners of the  large partnership. Being investment vehicles, these funds tend to invest  in other partnerships, as well as other types of business entities. One IRS  official said that these investments can affect the partner size of other  partnerships based on where they choose to invest (e.g., buying an  interest in other partnerships). For example, if an investment fund with a  million partners chose to invest in multiple small operating partnerships,  such as oil and gas companies organized as partnerships, all of those  partnerships would count as having more than a million partners as well.  One IRS official said the partnerships with more than a million partners  increased from 17 in tax year 2011 to 1,809 in tax year 2012. The official  attributed most of the increase to a small number of investments funds  that expanded their interests in other partnerships. If in the future those  investment funds choose to divest their interests in other partnerships, the  number of large partnerships would decrease significantly. Although the  reasons for the changes are not clear, from tax years 2008 to 2010, the  number of large partnerships with 500,000 or more direct and indirect  partners changed from 70 in 2008 to 1,088 in 2009, and decreased to 70  in 2010.
IRS data on large partnerships also show their complexity, as measured  by the number of partners and extent of tiering, or levels, below the large  partnership. Almost two-thirds of large partnerships in 2011 had more  than 1,000 direct and indirect partners, although hundreds of large  partnerships had more than 100,000. See figure 2 for more detail.
In 2011, about two-thirds of large partnerships had at least 100 or more  pass-through entities in the partnership structure. Because almost all  large partnerships tend to be part of multitiered networks, their partners  could be spread across various tiers below those partners that have a  direct interest in the partnership. For example, in 2011, 78 percent of the  large partnerships had six or more tiers.
Determining the relationships and how income and losses are allocated  within a large partnership structure through multiple pass-through entities  and tiers is complicated. For example, in figure 3, the allocation from the  audited partnership on the far left side of the figure crosses eight pass- through entities along the bold path before it reaches one of its ultimate  owners on the right. This path also may not be the only path from the  audited partnership to the ultimate owner.
While figure 3 appears complex, it has only 50 partners and 10 tiers.  Large partnership structures could be much more complex. In 2011, as  noted above, 17 had more than a million partners. According to one IRS  official, there are several large partnerships with more than 50 tiers.
section_title: IRS Audits Few Large Partnerships Due to Challenges Presented by the Complexity of Both the Audit Procedures and the Large Partnership Structures
subsections: section_title: IRS Audits Large Partnerships at a Much Lower Rate than Large Corporations and the Audits Produce Minimal Results for Audit Time Spent
paragraphs: IRS audits few large, complex partnerships. According to IRS data, in  fiscal year 2012, IRS closed 84 field audits of the 10,143 large  partnership returns filed in calendar year 2011—or a 0.8 percent audit  rate. This is the same audit rate we found for fiscal year 2012 in our  interim report, which defined large partnerships as having 100 or more  direct partners and $100 million or more in assets. The audit rate for  large partnerships remains well below that of C corporations with $100  million or more in assets, which was 27.1 percent in fiscal year 2012. See  table 1.
Table 1 also shows that most large partnership field audits closed from  fiscal years 2007 through 2013 did not find tax noncompliance. In 2013,  for example, 64.2 percent of the large partnership audits resulted in no  change to the reported income or losses. In comparison, IRS audits of C  corporations with $100 million or more in assets had much lower no  change rates. For example, audits of large corporations had a no change  rate of 21.4 percent in 2013.
When the field audits of large partnership returns did result in changes,  the changes to net income that the audits recommended were minimal in  comparison to audits of large corporations, as shown in table 2. This  could be because positive changes on some audits were cancelled out by  negative changes on other audits. In 3 of the 7 years, the total  adjustments from the field audits were negative. That is, they favored the  large partnerships being audited. This did not occur for audits of large  corporations. See table 2.
In terms of audit costs, the number of days and hours spent on the audits  of large partnerships in fiscal year 2013 has increased since fiscal year  2007, but varied from year to year in the interim, as shown in table 3. In  contrast, the audit days and hours spent on audits of large corporation  are decreasing while obtaining audit results that are noticeably better than  those of large partnership audits.
IRS does not track its audit results for large partnerships and therefore  does not know what is causing the results in tables 1, 2, and 3.  Consequently, it is not clear whether the results are due to IRS selecting  large partnerships that were tax compliant versus IRS not being able to  find noncompliance that did exist.
section_title: Several Challenges Related to Complexity Hinder IRS’s Audits of Large Partnerships
paragraphs: The high no change rates and minimal adjustment amounts for IRS audits  of large partnerships may be due to a number of challenges that can  cause IRS to spend audit time on administrative tasks, or waiting on  action by a large partnership or IRS stakeholder rather than doing actual  audit work. Under the Tax Equity and Fiscal Responsibility Act of 1982  (TEFRA), the period for auditing partnerships does not expire before 3  years after the original due date of the return or date of return filing,  whichever is later. IRS on average takes approximately 18 months after  a large partnership return is received until the audit is started, leaving on  average another 18 months to conduct an audit, as illustrated in figure  4.
Once a large partnership audit has been initiated, it falls under the  TEFRA audit procedures. Congress enacted the TEFRA audit procedures  in response to concerns about IRS’s ability to audit partnership returns.  According to the congressional Joint Committee on Taxation (JCT), the  complexity and fragmentation of partnership audits prior to TEFRA,  especially for large partnerships with partners in many audit jurisdictions,  resulted in the statute of limitations expiring for some partners while other  partners were required to pay additional taxes as a result of the audits.  TEFRA addressed these issues by altering the statute of limitations and  requiring each partner of a partnership to report certain items like income,  consistent with how the partnership reports them. However, according to  IRS officials and in focus groups we held with IRS auditors, using the  TEFRA procedures to audit large, complex partnership structures present  a number of administrative complexities for IRS. These complexities may  reduce the time IRS spends on actual audit work, adversely affecting IRS  audit results for large partnerships. For example, one of the primary  challenges for doing large partnership audits under TEFRA that IRS focus  group participants reported was identifying the Tax Matters Partner  (TMP). The TMP is the partnership representative who is to work with IRS  to facilitate a partnership audit. The responsibilities of the TMP include (1)  supplying IRS with information about each partner, (2) keeping the  partners of the partnership informed and getting their input on the audit,  and (3) executing a statute of limitations extension, if needed. Without  being able to identify a qualified TMP in a timely manner, IRS may  experience delays during large partnership audits.
IRS focus group participants cited numerous examples of difficulties in  identifying the TMP. One difficulty is that the TMP can be an entity, not a  person. If an entity is designated as the TMP, IRS has to track down an  actual person to act as a representative for the TMP. Focus group  participants said that some large partnerships do not designate a TMP or  designate an entity as TMP to delay the start of the audit, which would  limit the audit time remaining under the statute of limitations.
Entities will often be elusive about designating the TMP. The entities will  use this tactic as a first line of defense against an audit.
The burden for ensuring that the TMP meets the requirements of TEFRA  largely falls on IRS. Time spent identifying a qualified TMP, according to  IRS focus group participants, could take weeks or months. As shown in  figure 4, IRS has a window of about 1.5 years to complete large  partnership audits. A reduction of a few months from the 1.5 years IRS  has to complete large partnership audits means that the time IRS has for  the audit would be markedly reduced.
Another challenge TEFRA poses is determining the extent to which IRS  passes through audit adjustments to the taxable partners in a large  partnership structure. In that large partnerships are nontaxable entities,  TEFRA requires that audit adjustments be passed through to the taxable  partners, unless the partnership agrees to pay the related tax at the  partnership level. To pass through the audit adjustments to the taxable  partners, IRS has to first link, or connect, the partners’ returns to the  partnership return being audited. However, IRS officials said linking a  large number of partners’ returns can be a significant drain on IRS’s  resources. If a large partnership has hundreds or thousands of partners at  multiple tiers, the additional tax owed by each partner as a result of large  partnership audit may not be substantial enough to be worth passing  through once those partners’ returns are linked. If the audit adjustment  is lower than a certain level, IRS will not pass it to the taxable partners;  and the time and resources spent linking the partners’ returns, and  preparing a plan to pass through the audit adjustment to certain taxable  partners’ returns, becomes effectively meaningless.
Aside from the TEFRA challenges, another challenge involves the  complexities arising from large partnership structures, which hinder IRS’s  ability to identify tax noncompliance with complex tax laws. For example,  IRS officials reported having difficulty in identifying the business purpose  for the large partnerships or in determining the source of income or losses  within their structures (i.e. knowing which entity in a tiered structure is  generating the income or losses). Without this information, it is difficult for  IRS to determine if a tax shelter exists, an abusive tax transaction is  being used, and if income and losses are being properly characterized.
I think noncompliance of large partnerships is high because a lot of what  we have seen in terms of complexity and tiers of partnership structures…  I don’t see what the driver is to create large partnership structures other  than for tax purposes to make it difficult to identify income sources and  tax shelters.
To help IRS auditors better understand the complexity of the TEFRA audit  procedures and the large partnership structures, various IRS  stakeholders and specialists are to provide support during the audit.  However, IRS focus group participants stated that they do not have the  needed level of timely support. These include TEFRA coordinators to help  with the TEFRA audit procedures, IRS counsel to help navigate the  TEFRA audit procedures and provide input on substantive tax issues, and  specialists who have expertise in a variety of areas. The support provided  by IRS stakeholders is important because many IRS focus group  participants said that their knowledge of partnership tax law was limited  and they may only work on a partnership audit once every few years.
The challenges identified by IRS are not recent occurrences but may  have grown over time as the number and size of large partnerships has  grown. For example, in 1990, the Department of the Treasury (Treasury)  and IRS reported that applying TEFRA to large partnership audits  resulted in an inefficient use of limited IRS resources. They cited a  number of reasons for the inefficient use of resources, such as having to  collect and review information on a large number of partners and the  difficulty of passing through audit adjustments to those partners.
section_title: IRS Has Limited Ability to Fully Address Challenges
paragraphs: IRS by itself cannot fully address the tax law and resource challenges in  auditing large partnership returns. For example, IRS cannot make the  structures or laws less complex and cannot change the TEFRA audit  procedures in statute. In addition, IRS has recently experienced budget  reductions, constraining the resources potentially available for large  partnership audits.
Despite these limitations, IRS has initiated efforts that may help address  the challenges auditing large partnership returns. First, IRS can  sometimes use a closing agreement to resolve an audit under the TEFRA  audit procedures, if both IRS and the partnership agree to its terms. This  agreement allows the tax owed from the net audit adjustment at the  highest marginal tax rate to be collected at the partnership level, meaning  IRS does not have to pass through the audit adjustments to the taxable  partners. IRS does not track the number of closing agreements but IRS  officials said that IRS enters into relatively few. IRS officials are  encouraging audit teams to pursue closing agreements for large  partnership audits. However, closing agreements come with challenges  because the partnership must be willing to agree and the IRS review  process can be extensive.
Aside from closing agreements, the IRS efforts affect steps IRS takes at  the beginning of an audit—such as understanding the complexity of large  partnerships and selecting returns for audits. However, IRS has not yet  determined the effectiveness of these efforts.
The Chairman of the House of Representatives Committee on Ways and  Means and the Administration have also put forth proposals to address  some of challenges associated with the TEFRA audit procedures. While  the proposals differ somewhat and apply to partnerships with different  numbers of partners, both would allow IRS to collect tax at the  partnership level instead of having to pass audit adjustments through to  the taxable partners.
In our ongoing work on large partnerships, we are assessing options for  improving the large partnership audit process and, if warranted, will offer  reforms for Congress to consider and recommendations to IRS.
Chairman Levin, Ranking Member McCain, and Members of the  Subcommittee, this completes my prepared statement. I would be  pleased to respond to any questions that you may have at this time.
section_title: Agency Comments
paragraphs: We provided a draft of this testimony to IRS for comment. IRS provided  technical comments, which were incorporated, as appropriate.
section_title: Contact and Acknowledgements
paragraphs: If you or your staff have any questions about this testimony, please  contact me at (202) 512-9110 or whitej@gao.gov. Contact points for our  Offices of Congressional Relations and Public Affairs may be found on  the last page of this statement. GAO staff who made key contributions to  this testimony included Tom Short, Assistant Director, Vida Awumey,  Sara Daleski, Deirdre Duffy, Robert Robinson, Cynthia Saunders, Erik  Shive, Albert Sim, A.J. Stephens, and Jason Vassilicos.
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