Large Partnerships: With Growing Number of Partnerships, IRS Needs to Improve Audit Efficiency
Published: 2014-09-18T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: More businesses are organizing as partnerships while fewer are C corporations. Unlike C corporations, partnerships do not pay income taxes but pass on income and losses to their partners. Large partnerships (those GAO defined as having $100 million or more in assets and 100 or more direct and indirect partners) are growing in number and have complex structures. Some partnerships create tiers of partnerships with hundreds of thousands of partners. Tiered large partnerships are challenging for IRS to audit because tracing income through the tiers to the ultimate partners is complex.
GAO was asked to assess IRS's ability to audit large partnerships. GAO's objectives include: 1) determine what IRS knows about the number and characteristics of large partnerships, 2) assess IRS's ability to audit them, and 3) assess IRS's efforts to address the audit challenges. GAO analyzed IRS data from 2002 to 2011 and IRS audit documentation, interviewed IRS officials, met with IRS auditors in six focus groups, and interviewed private sector tax lawyers knowledgeable about partnerships.
section_title: What GAO Found
paragraphs: The number of large partnerships has more than tripled to 10,099 from tax year 2002 to 2011. Almost two-thirds of large partnerships had more than 1,000 direct and indirect partners, had six or more tiers and/or self reported being in the finance and insurance sector, with many being investment funds.
The Internal Revenue Service (IRS) audits few large partnerships. Most audits resulted in no change to the partnership's return and the aggregate change was small. Although internal control standards call for information about effective resource use, IRS has not defined what constitutes a large partnership and does not have codes to track these audits. According to IRS auditors, the audit results may be due to challenges such as finding the sources of income within multiple tiers while meeting the administrative tasks required by the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) within specified time frames. For example, IRS auditors said that it can sometimes take months to identify the partner that represents the partnership in the audit, reducing time available to conduct the audit. TEFRA does not require large partnerships to identify this partner on tax returns. Also under TEFRA, unless the partnership elects to be taxed at the entity level (which few do), IRS must pass audit adjustments through to the ultimate partners. IRS officials stated that the process of determining each partner's share of the adjustment is paper and labor intensive. When hundreds of partners' returns have to be adjusted, the costs involved limit the number of audits IRS can conduct. Adjusting the partnership return instead of the partners' returns would reduce these costs but, without legislative action, IRS's ability to do so is limited.
Note: A 3-year statute of limitations governs the time IRS has to conduct partnership audits, which is about equally split between the time from when a return is received until the audit begins and the time to do the audit. IRS then has a year to assess the partners their portion of the audit adjustment.
IRS has initiated three projects—one of which is under development—to make large partnership audit procedures more efficient, such as identifying higher risk returns to audit. However, the two projects implemented were not developed in line with project planning principles. For example, they do not have clear and measurable goals or a method for determining results. As a consequence, IRS may not be able to tell whether the projects succeed in increasing audit efficiency.
section_title: What GAO Recommends
paragraphs: Congress should consider requiring large partnerships to identify a partner to represent them during audits and to pay taxes on audit adjustments at the partnership level. IRS should take multiple actions, including: define large partnerships, track audit results using revised audit codes, and implement project planning principles for the audit procedure projects. IRS agreed with all the recommendations, but noted that revision of the audit codes is dependent upon future funding.

section_title: Letter
paragraphs: In recent decades, there has been a dramatic shift in the way American  businesses organize and pay taxes. The shift has been towards legal  structures known as pass-through entities, such as partnerships, and  away from C corporations that are subject to the corporate income tax.  For example, between 2002 and 2011, the number of partnerships  increased 47 percent to 3.3 million while the number of C corporations  decreased by 22 percent to 1.6 million. Partnerships do not generally pay  income taxes—they pass their income and losses through to their  partners who report them on their income tax returns and make any  associated tax payments.
Large partnerships, which we define as those with 100 or more direct and  indirect partners and $100 million or more in assets, have grown even  faster. From 2002 to 2011, the number of large partnerships more than  tripled to more than 10,000 and large partnerships hold trillions of dollars  of assets.
Large partnerships create a number of tax law enforcement challenges  for the Internal Revenue Service (IRS) that we have described in recent  reports. The challenges are due to the complexity of large partnerships  as well as the number of partners. Since partnerships can be partners in  other partnerships, large partnerships frequently have tiers of  partnerships, creating indirect partners. Such complex structures make it  difficult for IRS to find the source of income and then trace it through the  tiers to the ultimate taxable partners. There are legitimate reasons for  businesses to set up complex structures of entities, such as isolating one  part of a business from liability for the losses of another part.
Because of the growth of large partnerships and the challenges IRS faces  in auditing large partnerships, you asked us to assess IRS’s ability to  ensure compliance with the tax laws. Specifically, this report (1)  determines what IRS knows about the number and characteristics of  large partnerships; (2) determines what IRS knows about the costs and  results of audits of large partnership returns and assesses IRS’s ability to  effectively conduct such audits; and (3) identifies and assesses IRS’s  efforts to address the challenges of auditing large partnership returns.
To determine the number and characteristics of large partnerships, we  obtained data from IRS on tax returns filed by large partnerships for tax  years 2002 to 2011.the number of partnerships by asset size, number of direct and indirect  partners, number of tiers, and industry sector. To determine what IRS  knows about the costs and results of audits of large partnership returns,   Using these data, we analyzed and reported data on  we obtained audit data from IRS for fiscal years 2007 to 2013. We  compared the costs and results of large partnership audits to audits of  corporate returns of the same asset size.
To assess the effectiveness of IRS audits of large partnership returns, we  reviewed relevant statutes, IRS data on large partnerships, IRS policies  and procedures on partnership audits, and our recent reports on  partnerships. partnership audit procedures outlined in statute and internal controls  standards for the federal government. This information included our  interviews with IRS officials and private sector lawyers knowledgeable  about partnerships as well as six focus groups with IRS auditors who  have worked on large partnership audits. The results of the 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.
See GAO-14-379R, GAO-14-746T, and GAO-14-453.
GAO reports. These criteria were identified by conducting a literature  review of a number of guides on project management and business  process reengineering.
For the purposes of this review, we determined that the data used in our  analysis were reliable and all dollar values have been adjusted for  inflation to tax year or fiscal year 2014. Our data reliability assessment  included reviewing relevant documentation, interviewing knowledgeable  IRS officials, and electronic testing of the data to identify obvious errors or  outliers. For additional details on our scope and methodology, see  appendix I.
We conducted this performance audit from October 2013 to September  2014 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: Background
paragraphs: Forms of business organization and their  tax treatment  Partnership:  generally an unincorporated  entity with two or more members that  conducts a business, does not pay income  taxes, but rather passes income or losses  through to their partners, which must include  that income or loss on their income tax  returns.  C Corporation: a corporation that is generally  taxed at the entity level under subchapter C of  the Internal Revenue Code (IRC).  S Corporation: a corporation that meets  certain requirements and elects to be taxed  under subchapter S of the IRC, which  provides that in general income and losses be  passed through to its shareholders.
For tax purposes, a partnership is generally an unincorporated  organization with two or more members that conducts a business and  divides profits. Partnerships generally report their income on Form 1065,  U.S. Return of Partnership Income. Partnerships usually do not pay  income taxes but pass—or allocate—the net income or losses to  partners, who pay any applicable taxes. Partnerships report the share of  income or losses accruing to each partner on a Schedule K-1 with copies  going to the partners and to IRS. Partners can be individuals or other  entities such as corporations or other partnerships.
Having no statutory, IRS, or industry-accepted definition of a large  partnership, we have defined a large partnership in two ways: 1) as  having 100 or more direct and indirect partners and $100 million or more  in assets, and 2) as having 100 or more direct partners and $100 million  or more in assets. Including just direct partners does not capture the  entire size and complexity of large partnership structures. Accounting for  indirect partners does, but it also raises the issue of counting income and  assets more than once (described below). In this report, we generally use  the definition that includes direct and indirect partners but sometimes use  both definitions when the distinction might matter.
subsections: section_title: Key Terms and Examples of Partnership Structures
paragraphs: Partnerships can be structured as tiers of pass-through entities creating  direct and indirect partners. Table 1 defines key terms for a partnership  structure.
See figure 1 for an example of a simple tiered partnership structure.
For a partnership structure with multiple partners linked in networks with  other partnerships, the partners, assets, and income may be counted  more than once as seen in figure 2.
section_title: IRS Audit Process for Large Partnership Returns
paragraphs: Large partnership audits typically involve two separate steps. One step is  the field audit, which is a detailed examination of the partnership’s tax  return (Form 1065) and supporting books and records to determine  whether income and losses are properly reported. The field audit may  recommend adjustments to the income and losses.
The other step is called a campus audit.partnerships to the tax returns of their direct and indirect partners.  Adjustments to income or losses from the field audit may be passed  through to the taxable partners responsible for paying any additional tax,  based on the partners’ shares in the partnership. Although IRS counts  campus audits as audits, they usually do not involve an examination of a  taxpayer’s books and records.
section_title: Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA)
paragraphs: In response to concerns about IRS’s ability to audit partnership returns,  Congress enacted specific rules regarding partnerships audits in  TEFRA. TEFRA audit procedures were intended to streamline IRS’s  partnership audit process while ensuring the rights of all partners.  Before TEFRA, IRS audited partners separately, leading to inconsistent  treatment and making it hard to detect tax shelters. According to the  congressional Joint Committee on Taxation (JCT), the complexity and  fragmentation of the audits—especially for large partnerships with  partners in many locations—led to some audits of partners’ returns  ending at varying times and some partners paying additional taxes while  others did not. See table 2 for key features of TEFRA.
Ideally, once a TEFRA audit begins, it would proceed as outlined in figure  3.
section_title: Electing Large Partnership (ELP) Audit Procedures
paragraphs: According to the U.S. Department of Treasury (Treasury) and IRS,  applying TEFRA to audits of large partnerships became an intensive and  inefficient use of limited IRS resources as IRS spent more and more time  on administrative tasks. As a result, Congress established the Electing  Large Partnerships (ELP) procedures as part of the Taxpayer Relief Act  of 1997. In general, the procedures apply to partnerships with 100 or  more direct partners in a taxable year that elect this alternative reporting  and audit framework. The ELP audit procedures differ from the TEFRA  procedures in two key ways: partnerships (1) may pay tax on audit  adjustments instead of the partners, and (2) must report fewer items to  the partners.
section_title: IRS Resource Constraints
paragraphs: As we have previously reported, IRS’s appropriations declined by $855  million, or 7 percent, and IRS staffing declined by more than 10,000 full- time equivalents, or 11 percent, between fiscal years 2010 and 2014.Most of this staffing decline occurred in IRS enforcement, which is  responsible for ensuring that tax returns, including partnership returns,  comply with the tax laws.
section_title: Large Partnerships Have Grown in Number, Size, and Complexity Since 2002
subsections: section_title: Businesses Have Shifted From Organizing as C Corporations to Partnerships and Other Pass-through Entities in Recent Years
paragraphs: During tax years 2002 through 2011, the number of partnerships and S  corporations of all sizes increased 47 percent and 32 percent,  respectively, while the number of C corporations decreased 22 percent.See figure 4.
section_title: The Number of Large Partnerships Has More Than Tripled
paragraphs: During tax years 2002 through 2011, the number of large partnerships  with 100 or more direct and indirect partners as well as $100 million or  more in assets more than tripled to 10,099—an increase of 257 percent.  Over the same years, total assets of these large partnerships (without  accounting for double counting) increased 289 percent to almost $7.5  trillion.for various asset sizes.
section_title: Most Large Partnerships Have Complex Structures with Thousands of Partners and Multiple Tiers
paragraphs: Almost two-thirds of large partnerships had 1,000 or more direct and  indirect partners in tax year 2011, but hundreds of large partnerships had  more than 100,000 partners. Large partnerships with the most direct and  indirect partners had the greatest increase from tax years 2002 to 2011.  See figure 6.
The number of large partnerships varies considerably from year to year  due in part to investment choices made by other large partnerships. One  IRS official said that 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 investment funds that  expanded their interests in other partnerships. If those investment funds  choose to divest their interests in other partnerships, the number of large  partnerships would decrease significantly.
Tiering contributes to complexity. In tax year 2011, more than two-thirds  of large partnerships had at least 100 or more pass-through entities and  36 percent had at least 1,000 or more pass-through entities as direct and  indirect partners. These pass-through entities may be direct partners or  may exist at various tiers below the direct partners. There is some  evidence that large partnership structures are becoming more complex. In  tax year 2011, 78 percent of the large partnerships had six or more tiers  compared to 66 percent in tax year 2002.
Tiering complicates determining the relationships and allocations of  income and losses within a large partnership structure. For example, in  figure 7, the allocation from the audited partnership on the far left side of  the figure passes through eight partnerships along the bolded 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 this example of a partnership structure is complex, it has only 50  partners and 10 tiers. Large partnership structures could be much more  complex. In 2011, 17 large partnerships had more than a million partners.  According to an IRS official, several large partnerships have more than 50  tiers.
section_title: Large Partnerships Are Concentrated in the Finance Sector
paragraphs: In tax year 2011, about 73 percent of large partnerships reported being in  the finance and insurance sector, up from 64 percent in tax year 2002  (see table 3). About 87 percent of those in the finance and insurance  sector in tax year 2011 engaged in financial investment activities, of  which about 70 percent reported $1 billion or more in assets.
As we previously found, many of the large partnerships in the finance and  insurance sector are investment funds, such as hedge funds and private  equity funds, which are pools of assets shared by investors. See  appendix II for additional data on the number and characteristics of large  partnerships.
section_title: IRS Audits Few Large Partnerships Due to Challenges Presented by the Complexity of Both the Partnership Structures and Audit Procedures
subsections: section_title: IRS Audits Less Than 1 Percent of Large Partnerships
paragraphs: IRS audits few large, complex partnerships. According to IRS data, in  fiscal year 2012, IRS closed 84 field audits—or a 0.8 percent audit rate.This audit rate is well below that of C corporations with $100 million or  more in assets, which was 27.1 percent in fiscal year 2012. See table 4.
This audit rate does not depend on whether large partnerships are  defined to include direct and indirect partners or only direct partners. Our  interim report, which focused on only direct partners in defining large  partnerships, also showed a 0.8 percent audit rate in 2012.
It is possible that some large partnership audits in table 4 are audits of  different partnerships within the same large partnership structure. For  example, if IRS audits one large partnership and then discovers that it  needs to audit another large partnership in the same complex structure,  those would count as two separate audits. Available IRS data did not  allow us to determine how often this occurred.
section_title: Audits of Large Partnerships Resulted in Minimal Changes to Partnership Returns
paragraphs: Table 5 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, as also shown in table 5. In addition, IRS audits of all  partnerships, not just large partnerships, also had a lower no change rate  of 47 percent in fiscal year 2013.
According to IRS focus group participants, large partnership returns have  the potential for a high tax noncompliance risk. However, it is not clear  whether the high no change rate for large partnership audits is due to IRS  selecting large partnerships that were tax compliant or is due to an  inability of IRS audits to identify noncompliance, as discussed below.
When field audits of large partnerships resulted in changes, the  aggregate amount was minimal, as shown in table 6. This could be  because positive changes on some audits were cancelled out by negative  changes on other audits. In 3 of the 7 years shown in table 6, 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.
IRS data show that its large partnership audits used fewer resources than  large corporate audits, but still required significant audit staff time, as  shown in table 7.
These field audit time measures for large partnerships do not cover all  audit costs, such as the time spent passing through audit adjustments at  the campus. For example, if the campus passes through audit  adjustments to 100 partners of one large partnership (which means  opening 100 campus audits), the total cost of the related large partnership  audit may be significantly larger than the field audit time accounted for  partnerships in table 7. However, the campus does not track the total  hours spent working all the partners’ returns related to a partnership  return audited in the field due to limitations associated with IRS  information systems, which are discussed below. Campus officials noted  that working returns related to large partnerships require significant time  and resources given their growing complexity and size.
section_title: IRS Reporting of Partnership Audit Data Does Not Provide Clear Picture of Large Partnership Audits
paragraphs: IRS data that report audit results for partnerships do not break out large  partnerships, which would help inform audit resource allocation decisions.  Without such a break out, our analysis of audit data for large partnerships  relied on combining various databases. According to standards for  internal control in the federal government, managers need accurate and  complete information to help ensure efficient and effective use of  resources. IRS officials acknowledged that they need a better  understanding of large partnership audits to improve resource allocation.
The problem arises because IRS’s audit data codes—known as activity  codes—are not specific enough to identify large partnerships. IRS uses  its activity codes to set goals for the number of returns IRS plans to audit  in a fiscal year and track audit results. Because they do not identify large  partnership returns, the current activity codes do not allow IRS to do the  kind of analysis needed to plan resource usage, including the level of  audit and support staff needed, for large partnership audits.
IRS has developed new activity codes that would distinguish partnership  returns based on asset size and the type of income reported; but they are  not scheduled to begin reporting the new activity codes until fiscal year  2017 due to resource limitations. IRS has not decided which activity  codes would be used to define large partnership returns. Further, the new  activity codes do not account for the number of partners, which IRS has  identified as a major driver of resource usage for large partnership  audits—particularly for the work done at the campus. If these IRS activity  codes do not account for such a driver of resource usage, IRS will not be  able to make effective resource allocation decisions.
Revising the activity codes requires defining a large partnership for audit  purposes, which IRS has not done. The exact definition matters less than  ensuring that one definition is consistently applied so that there is  agreement on the scope of large partnership audit efforts and results can  be assessed.
IRS also does not distinguish between field audits and campus audits in  counting the number of large partnership audits. When calculating its  audit rate for all partnerships, IRS accounts for both field audits and  campus audits, which misrepresents the number of audits that actually  verify information reported on tax returns. Unless IRS separately  accounts for field and campus audits, it cannot accurately measure audit  results.
section_title: Several Challenges Related to Complexity May Limit IRS’s Ability to Audit Large Partnerships and to Recommend Changes
paragraphs: IRS officials said that they do not have sufficient data on the results from  field audits of large partnerships to know what is driving the high no   Our focus groups with IRS field  change rate and minimal tax changes.auditors and interviews with IRS officials, however, provided insights on  the challenges to finding noncompliance in field audits.
subsections: section_title: Complex Large Partnership Structures Make Audits and Detecting Noncompliance Challenging
paragraphs: The complexities arising from large partnership structures challenge IRS’s  ability to identify tax noncompliance. For example, IRS officials reported  having difficulty identifying the business purpose for the large  partnerships or knowing which entity in a tiered structure is generating the  income or losses. In these cases, IRS auditors said they do not know with  which partner or tier of the partnership structure to start the audit. Without  finding the source of income and losses, it is difficult for IRS to determine  whether a tax shelter exists, an abusive tax transaction is being used, or if  income and losses are being properly characterized. Focus group  participants said that complex structures could mask tax noncompliance.  For example, one participant said  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.
IRS officials stated that determining compliance is especially challenging  when auditing the returns of hedge funds that often have an interest in  many other partnerships and in investments—such as financial  derivatives that are complex and constantly changing, and can involve  noncompliance, as we have previously found. Focus group participants  noted that the complexity requires them to invest extensive time to  research and understand the structure of large partnerships and technical  tax issues. For example, one focus group participant noted the difficulty of  auditing the returns of large, complex partnerships:  …  income is pushed down so many tiers, you are never  able to find out where the real problems or duplication of deductions  exist.  The reporting of income, expenses could be duplicated but  there is no way to figure it out unless you drill down and audit all tiers,  all tax returns.
section_title: TEFRA Audit Procedures Add Complexity to Audits of Large Partnerships
paragraphs: As the number and complexity of large partnerships have increased,  aspects of the TEFRA audit procedures have become an impediment,  according to focus groups and interviews with IRS officials.
TEFRA Reduces Time IRS Can Actually Spend on Audits  IRS focus group participants stated that the interaction of TEFRA  procedures with increasingly complex partnership structures has reduced  the amount of time to effectively audit the return within the statute of  limitations. A 3-year statute of limitations governs the time in which IRS  must complete its audits of partnerships, which begins on the due date of  the return or date of return filing, whichever is later. IRS on average takes  about 18 months after a large partnership return is received until the audit  is started, leaving another 18 months to actually conduct an audit, as  illustrated in figure 8. After the field audit, TEFRA generally requires that  any audit adjustments be passed through to partners within a 1-year  assessment period.
Focus group participants said that they sometimes run out of time on the  statute of limitations and have to close the audit as no change. IRS has  no data that supports this claim as it does not break out audit results by  large partnerships, as discussed earlier.
Identifying the Tax Matters Partner (TMP) Can Take Months  TEFRA defines the responsibilities of the TMP, such as providing  information to IRS as well as communicating with partners, which  generally help to facilitate the audit. Without a TMP, IRS is not able to  conduct the audit. Further, if the audit proceeds without a qualified TMP,  the partners may challenge any settlement agreed to between the IRS  and the unqualified TMP at the conclusion of the audit, so IRS takes  steps to ensure that any TMP is a qualified TMP.
IRS focus group participants said that identifying a qualified TMP is a  primary challenge in large partnership audits. The burden of doing so falls  largely on IRS, taking time and effort away from doing the actual audit  work. For example, TEFRA does not require partnerships to designate a  TMP on their returns. In addition, TEFRA allows the TMP to be an entity,  not a person. In either case, IRS auditors spend time requesting that the  partnership designate a TMP or tracking down an actual person to act as  a representative for the TMP—unless the partnership chose to list that  person on the Form 1065. IRS focus group participants cited various  reasons for not being able to immediately identify the TMP. Some said  that large partnerships are purposely unclear about the TMP as an audit- delay strategy. As one participant said:  Entities will often be elusive about designating the Tax Matters  Partner. The entities will use this tactic as a first line of defense  against an audit.
If a large partnership does not designate a TMP on the partnership return,  IRS will provide the partnership the opportunity to do so.  If the  partnership does not, TEFRA requires that the partner with the largest  profit interest automatically becomes the TMP. However, if IRS  determines that it is impracticable to apply this rule, then IRS may  designate the TMP.before giving the partnership an opportunity to designate a TMP because  the IRS designation may be opposed by the partners and IRS needs to  collect information to find a partner that meets the criteria. As a  consequence, exercising this authority can still mean that the start of  audit is delayed. However, if IRS were to move directly to the largest  profit interest rule or chose to designate the TMP using its existing  authority instead of reaching out to the partnership, IRS could save  valuable time during the average 18-month window it has to completes  the audit. IRS does not track data on the time spent identifying the TMP.  Focus group participants said that identifying and qualifying the  designated TMP could take weeks or months. Losing a few months from  the 18 months to audit a large partnership could be significant to IRS field  auditors.
IRS officials said that they are hesitant to do so  IRS officials said IRS has issued new job aids and training on identifying  the TMP, clarified TMP requirements, and added a section about TEFRA  in the December 2013 revision of IRS Publication 541, Partnerships.  However, these steps do not solve the fundamental problem of limited  audit time being lost while identifying a TMP. A legislative change to  TEFRA requiring all large partnerships to designate a TMP on their tax  returns and to provide updated TMP information to IRS once an audit  starts would solve the problem. Without such a change, IRS’s field audits  of large partnerships are inefficient which hinders its ability to fulfill its  mission of ensuring tax law compliance. The costs of such a legislative  change should be low. There would be no increased costs to IRS—the  change would reduce IRS’s costs. Partnerships already have partners  responsible for filing tax returns so designating a TMP should not be  onerous.
IRS Has Difficulty Utilizing the 45-Day Rule Due to Complexity of  Large Partnerships  Another TEFRA audit procedure that is meant to benefit IRS but is difficult  to use is the TEFRA 45-day rule.withdraw its notification to the TMP about the start of the audit, within 45   IRS's TEFRA regulations allow IRS to  days of notifying the TMP. If IRS does so within 45 days, IRS can close  the audit as no change without having to notify the partners.
IRS focus group participants said that they often do not have sufficient  information to determine whether to close an audit within 45 days. In  addition, time spent identifying the TMP reduces the time available to  make this determination. As a result, of the 61 field audits of large  partnerships closed in fiscal year 2013 as no change, none were closed  within the 45-day period. its regulation to lengthen this period for withdrawing an audit notice  beyond 45 days without having to notify all the partners of the withdrawal.  Extending the notice withdrawal period would save IRS audit resources  and allow the resources to be more effectively used in ensuring tax law  compliance.
IRS has the authority under TEFRA to amend  Passing Through Audit Adjustments to Numerous Partners May Not  be Worth the Effort  TEFRA generally requires that audit adjustments be passed through to  the taxable partners. Although IRS does not track the costs for the  campus to pass field audit adjustments through to the partners, campus  officials said the costs are high for a number of reasons.
The process of linking partnership returns (Forms 1065), Schedule K- 1s, and partners’ returns (Forms 1040) is largely manual and paper  driven. According to IRS officials, the campus information systems do  not have the capability to automate the process. Paper copies of all  these returns must be retrieved and linked in a very labor intensive  process.
The portion of the partnership audit adjustment that gets passed  through to each partner must be manually determined by using the  ownership share reported on the relevant Schedule K-1.
The regulation specifies that the 45-day rule starts when IRS notifies the TMP of the  partnership audit, which likely occurs after the audit start date. However, IRS does not  track this notification date. Thus, we counted how many audits closed within 45 days of  the audit start date as a proxy.
The Schedule K-1 information may not always be accurate, as we  have previously found, requiring IRS to contact the partnership and  review the partnership agreement to clarify ownership shares among  the partners.
A copy of the partnership agreement must usually be requested from  the partnership being audited and for potentially each partnership  within the partnership structure that is linked. Partnership agreements  may include special allocation for some income items that supersede  the ownership interest reported on the Schedule K-1.  Finding  special allocations requires detailed reviews of the partnership  agreements of the partnerships within the partnership structure.  According to IRS officials, this step cannot be automated. IRS officials  also said that partnerships could provide special allocation schedules  to IRS, which would eliminate the need to review the entire  agreement.
As a consequence, the process for passing audit adjustments through to  partners is costly and very time consuming. This limits the number of  large partnerships that IRS can audit. Furthermore, since IRS generally  has one year after the 3-year statute of limitations ends to pass through  adjustments, the campus has to start linking returns before it knows  whether there will be an audit adjustment or whether an adjustment will  be large enough to merit passing through. In a large partnership, dividing  the adjustment among hundreds or thousands of partners may result in  amounts that are so small that IRS deems them not worth the cost to  pass through. IRS officials said that they do not track how often the audit  adjustments are not passed through and how much unpaid tax is not  collected as a result. IRS campus officials estimated that they close  50,000 to 60,000 returns for all partnerships each year and further  estimated that 65 to 70 percent of these are closed without passing  through any adjustment.
IRC § 704(b) provides partnerships the option to use special allocations. They are  generally listed in the partnership agreement that specifies such things as the  partnership’s name and purpose, partner contributions, and management responsibilities.  The agreement is to specify ratios for passing through partnership income, losses,  deductions, and credits to the partners. information systems. IRS has requested funding in its fiscal year 2014  and 2015 budget proposals for an updated information system that would  allow it to automate the linking process and collect more robust data but  funding has not been approved.
Large Partnerships May Pay Tax on Audit Adjustments Rather Than  Pass Them Through to the Partners but Such Payments are Not  Widely Used  Current law allows large partnerships to pay a tax owed as determined by  audit adjustments at the entity level rather than passing the adjustments  through to partners, which would avoid all the costs of campus audits.  This is allowed under both the Electing Large Partnership (ELP) audit  procedures and under IRS procedures for closing audits with what is  called a closing agreement. However, few large partnerships elect to  become an ELP. Further, partnerships must voluntarily agree to use a  closing agreement to pay a tax at the entity level and few do so.
The Chairman of the House of Representatives Committee on Ways and  Means and the Administration have also put forth proposals to address  some of the challenges of auditing large partnerships. 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 it through to the taxable  partners. For example, the Administration developed a legislative  proposal to make the ELP audit procedures mandatory for partnerships  with 1,000 or more direct and indirect partners, known as the Required  Large Partnership proposal. IRS officials said that these legislative  proposals, if passed, would significantly help address challenges involved  with passing through audit adjustments.
These proposals would involve tradeoffs and decisions about how to treat  partners. For example, because the partners may be taxed at different tax  rates, the single tax rate applied to the net audit adjustment at the  partnership level may be different than the rate partners would pay if the  adjustment was passed through.
IRS Field Auditors Face Barriers Accessing Timely Support and  Training to Address Complexities  IRS focus group participants stated that they do not have the needed  level of timely support from IRS counsel, TEFRA coordinators, and  specialists. Focus group participants said that the support is critical  because they had limited knowledge of the technical tax issues for  partnerships and they may only work on a partnership audit once every  few years. Further, focus group participants stated that it can take weeks  or months to get needed input and planning audits is difficult because  they do not know how long it will take to get the needed stakeholder input.  Unexpected delays reduce the average18-month window of time for audit  work.
Focus group participants said that some IRS locations have only one  TEFRA coordinator to answer questions about partnership audits. For  example, IRS has one TEFRA coordinator to support all audits in New  York State. IRS officials said that the number of TEFRA coordinators  declined from 28 in fiscal year 2006 to 20 in May 2014 while workload  increased. One IRS official said that TEFRA coordinators have to respond  to requests for assistance and review and process TEFRA audits for  partnerships of all sizes, not only large partnerships. IRS officials said that  they plan to hire two coordinators in fiscal year 2014 and five in fiscal year  2015.
IRS counsel officials told us that they believe that the number of delayed  responses is fairly low, in contrast to what focus group participants said,  and IRS counsel strives to process all requests for legal advice within 45  days of receipt. However, IRS counsel officials said that they do not track  the number of requests for large partnership audits; if known, the  response time would help IRS auditors to plan their audit work. Such a  change would be in line with IRS’s strategic plan, which has a strategic  objective on utilizing data to make timely, informed decisions.
In addition to help from stakeholders, IRS focus groups participants told  us that they have trouble accessing refresher courses on TEFRA and  partnership tax issues. IRS officials told us that IRS field auditors may not  understand that such training is available and can be taken with the  permission of their supervisors. They also said that such training is not  usually mandatory and some auditors may choose to not take it. Ensuring  IRS auditors have access to training would be in line with IRS’s current  strategic plan, which highlights the importance of building a talented  workforce. IRS officials stated that they are developing and have  implemented new tools and training to assist auditors with TEFRA rules  and procedures. However, IRS’s Large Business and International  division—the division responsible for auditing large partnership returns— experienced a 92 percent reduction in available training funds from 2009  to 2013.face training and relying on new virtual training courses on TEFRA and  partnership audits in general.
section_title: IRS Has Initiated Efforts That May Address Some Large Partnership Audit Challenges but Their Potential to Have Significant Impact Is Unclear
paragraphs: IRS has limited ability to directly address some of the challenges it faces  auditing large partnerships. For example, IRS cannot make tiered  partnerships less complex nor change the TEFRA audit procedures that  are set in statute. Nevertheless, IRS has initiated three projects to  improve its large partnership audit procedures. IRS has also begun an  effort to better manage enterprise risk.
subsections: section_title: Audit Procedures Improvement Projects Are Missing Some Planning and Evaluation Steps
paragraphs: Table 8 describes the three audit procedure projects and their potential  for addressing certain challenges based on our interviews with IRS  officials and reviews of available limited documents.
The two field audit-related projects (the Large Partnership CMT and  Large Partnership Procedures) started in 2013. IRS officials said that it  could be a few years before enough audits are completed to know  whether the two efforts worked as intended. The project to improve the  campus linkage process (Just-In-Time Linkage pilot) started August 2014,  but it is still under development and IRS provided limited documentation  detailing the development of this effort.
IRS has not developed the two field audit-related projects consistent with  project planning principles, as shown in table 9. These two projects did  not meet three of the five principles.
For the Large Partnership CMT, while IRS officials said that they plan to  collect data on five metrics, it is unclear how the metrics will be used to  monitor progress because they are not specific to the CMT. Without  following the principles in table 9, IRS may not be able to assess whether  the projects succeeded in making large partnership audits more efficient  and effective.
section_title: IRS Has Not Determined How Large Partnerships Should Be Incorporated Into Its Enterprise-Wide Risk Management
paragraphs: IRS began an enterprise risk management (ERM) program agency wide  in 2014. According to IRS documentation, IRS needed to evaluate how  risks are identified, prioritized, evaluated, and mitigated across the  agency. ERM objectives include deploying resources effectively,  identifying and managing cross-enterprise risks, identifying the level of  risk IRS is willing to absorb, aligning that risk level with strategies, and  reducing operational surprises, among others.
Large partnership audits and the challenges associated with them raise a  number of the issues listed as ERM objectives. Because of the lack of  information IRS currently collects and tracks about large partnership  audits, it does not have a very clear picture of how effectively its audit  resources are being utilized. Nevertheless, as large partnerships grow in  number, IRS will have to make decisions about whether to reallocate  audit resources away from other compliance work to conduct more large  partnership audits.
IRS has not yet determined how large partnerships will be incorporated  into its ERM effort. Without such a determination and without  documentation of the risks considered, IRS managers and external  stakeholders, including Congress, may lack a record of how compliance  risks associated with large partnerships were identified and prioritized.  We have previously reported on the benefits of risk management and  identified elements of a risk-management framework. Risk management  is a strategy for helping program managers and stakeholders make  decisions about assessing risk, allocating resources, and taking actions  under conditions of uncertainty. We recognize that IRS’s information  systems currently provide little data on large partnerships, as noted in  other sections of this report. Even though IRS is not explicitly planning for  how many large partnerships to audit each year, it is devoting resources  to such audits. IRS is implicitly making decisions about how to allocate  audit resources between large partnerships and other types of taxpayers.  A determination about how large partnership compliance risks are to be  identified and weighed against the compliance risks of other types of  taxpayers would better inform those decisions.
section_title: Conclusions
paragraphs: Large partnerships are a significant part of the economy and are  increasing in number, size, and complexity. However, the relatively low  rate at which IRS audits large partnerships and the minimal results  achieved raise concerns about IRS’s ability to ensure the tax compliance  of large partnerships. IRS has little data available to know why its audits  are finding so little tax noncompliance. That is because IRS has not  consistently defined “large partnership”—accounting for both the number  of partners and amount of assets—and devised a related coding system  to track any audit results. Without such data, IRS cannot conduct analysis  to identify ways to better plan and use IRS resources in auditing large  partnerships as well as analyze whether large partnerships present a high  noncompliance risk.
Without the data, testimonial evidence from IRS auditors indicates that  they feel challenged to audit complicated partnerships for compliance  without sufficient time and support. Existing audit procedures set in law  and in IRS regulations add to the time pressures and constrain IRS  auditors. Because so little is currently known about large partnership  noncompliance, it would be premature to try to design overall, long-term  solutions. An incremental approach could be based on what is currently  known, including legislative changes that Congress should consider as  well as actions that IRS should take.
Legislative changes could help IRS auditors deal with the time constraints  and reduce the resource demands of large partnership audits. Requiring  large partnerships to designate a qualified TMP that the field auditors can  contact is a relatively simple step that could reduce audit delays.  Requiring large partnerships to pay any tax due at the entity level would  also save resources but would not be a simple change. Such a change  would have differing impacts on partners who may be in different tax  brackets. The change would save the resources that are now devoted to  the paper driven, labor intensive process of passing adjustments through  to large numbers of partners. Paying taxes due on audit adjustments at  the entity level has advantages over other options for audit efficiency  gains such as automating the current paper driven process. Even if IRS  was given resources to modernize its campus information systems, parts  of the adjustment pass-through process would continue to require labor  intensive reviews of partnership agreements.
IRS can take several actions that would begin to provide better  information about large partnership compliance and audit results, or that  could lower audit costs. Actions that would be a first step towards better  information for analyzing large partnership compliance include developing  a consistent definition of a large partnership along with activity codes that  could be used to track audit results. To lower audit costs and avoid  wasting audit staff time, IRS could change its practice governing when to  use its authority to select a TMP, and the regulation which established the  number of days an audit can be open without triggering more costly  closing procedures. IRS could also better ensure that limited calendar  time is not wasted in an audit. It could do so by tracking delays in  providing expert support, clarify when auditors can expect such support,  and then use this information about the support that can realistically be  provided to better plan the number and scope of new audits, so that the  time allowed under the statute of limitations is more effectively used.
While IRS has initiated three projects to improve its audit procedures, it  has not followed project planning principles, including taking the steps  needed to effectively track the results for the two projects that have been  implemented. Without doing so, IRS will not know whether the projects  succeeded in improving audit procedures.
As large partnerships continue to grow in number and complexity, IRS will  have to make strategic decisions about whether to reallocate scarce audit  resources from other categories of taxpayers—perhaps from C  corporations which are declining in number—to conduct more large  partnership audits. IRS’s new Enterprise Risk Management program  provides a venue for weighing the compliance risks associated with large  partnerships against those of other types of taxpayers.
section_title: Matters for Congressional Consideration
paragraphs: Congress should consider altering the TEFRA audit procedures to:
Require partnerships that have more than a certain number of direct  and indirect partners to pay any tax owed as determined by audit  adjustments at the partnership level.
Require partnerships to designate a qualified TMP and, if that TMP is  an entity, to also identify a representative who is an individual and for  partnerships to keep the designation up to date.
section_title: Recommendations for Executive Action
paragraphs: We recommend that the Commissioner of Internal Revenue take the  following eight actions:
Track the results of large partnerships audits: (a) define a large  partnership based on asset size and number of partners; (b) revise  the activity codes to align with the large partnership definition; and (c)  separately account for field audits and campus audits.
Analyze the audit results by these activity codes and types of audits to  identify opportunities to better plan and use IRS resources in auditing  large partnerships.
Use existing authority to promptly designate the TMP under the  largest profits interest rule or some other criterion.
Extend the 45-day rule to give field audit teams more flexibility on  when to withdraw an audit notice.
Help field auditors for large partnership audits receive the support  they request from counsel staff, TEFRA coordinators, and IRS  specialists: (a) track the number of requests and time taken to  respond; (b) clarify when responses to their requests should be  expected; and (c) use the tracked and clarified information when  planning the number and scope of large partnership audits.
Clarify how and when field auditors can access refresher training on  TEFRA audit procedures and partnership tax law.
Develop and implement large partnership efforts in line with the five  leading principles for project planning and track the results to identify  whether the efforts worked as intended.
Make and document a determination about how large partnerships  are to be incorporated into the Enterprise Risk Management process.
section_title: Agency Comments and Our Evaluation
paragraphs: We provided a draft of this report for review and comment to the  Commissioner of Internal Revenue. We received written comments dated  September 8, 2014 from IRS’s Deputy Commissioner for Services and  Enforcement (for the full text of the comments, see appendix IV). We also  received technical comments from IRS, which we incorporated into the  final report where appropriate.
In its written comments, IRS agreed with our recommendations but said  two of our recommendations, related to revising IRS’s activity codes to  enable tracking large partnership audits and then analyzing audit results,  are dependent upon future funding. We acknowledge in the report the  resource constraints IRS currently faces. However, continuing to audit  large partnerships with limited ability to track and analyze audit results will  not help IRS make sound resource allocation decisions or improve audit  effectiveness.
We are sending copies of this report to the Secretary of the Treasury, the  Commissioner of IRS, and interested congressional committees. In  addition, the report is available at no charge on the GAO website at  http://www.gao.gov. 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. The names of  GAO staff who made key contributions to this report are listed in appendix  V.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: The objectives of this report are to (1) determine what IRS knows about  the number and characteristics of large partnerships; (2) determine what  IRS knows about the costs and results of audits of large partnership  returns and assess IRS’s ability to effectively conduct such audits; and (3)  identify and assess IRS’s efforts to address the challenges of auditing  large partnership returns.
To determine the number and characteristics of large partnerships, we  obtained data on tax returns filed by large partnerships from the  Enhanced Large Partnership Indicator (ELPI) file on partnerships for tax  years 2002 to 2011, and on the number of partnerships with 100 or more  direct and indirect partners and $100 million or more in assets. We  merged these data with data obtained from the Business Returns  Transaction File (BRTF). We analyzed and reported ELPI and BRTF data  by the total number of partnerships by asset size, direct partner size,  indirect partner size, industry group, and tiering depth. The ELPI data file  captures information about the ownership structure of large partnerships.  The ELPI file starts with a partnership and traces Schedule K-1  allocations through to the ultimate taxpayer. ELPI traces the ownership  structure of a partnership as long as either the depth is less than 11 tiers  or the ownership percentage is greater than 0.00001 percent and  therefore can present a picture of the approximate number of direct and  indirect partners in a partnership structure. The ELPI currently only has  data on partnerships that file a 1065 and not those that file a 1065-B. For  similar analysis on partnerships that file a 1065-B, see our prior work on  large partnerships.
To determine the number of IRS audits of large partnership returns and  the characteristics of those audits, we obtained data from the Audit  Information Management System (AIMS) and reported those partnership  returns subject to IRS audit that were closed during fiscal years 2007 to  2013.returns, we only reported those audits that were traditional IRS field  audits (in which IRS audited the books and records of a large partnership  return), and not campus audits (in which IRS usually passed audit  adjustments through to the related partners’ returns), as they are mainly  an administrative function and do not include an examination of the books  and records of the taxpayer return in question. We analyzed the results  from these data consistent with how IRS measures audit results, such as  the audit coverage rate (partnership returns subject to audit as a  percentage of the total partnership return population) and no change rate  (those audits that resulted in no change to the tax return from the audit),  and, where possible, without suppressing data due to disclosure  requirements, by asset size. We also analyzed the hours and days spent  on large partnership audits to assess the costs of these audits. Where  data were available, we compared these measures for large partnership  return audits to those for corporate return audits of the same asset size.
Once we identified the audited population of large partnership  To assess the effectiveness of IRS audits of large partnership returns, we  interviewed officials in the Office of Chief Counsel, Large Business and  International division, Small Business and Self-Employed division, and  Research, Analysis, and Statistics division. We also interviewed a number  of external private sector lawyers who are knowledgeable about  partnership tax law, reviewed academic research and literature, reviewed  IRS documentation, such as IRS policies and procedures on partnership  audits, and reviewed our recent reports on partnerships. We also  completed six focus groups with 30 IRS team coordinators and managers  on the challenges associated with completing audits of large partnership  returns. These team coordinators and managers were selected for our  focus groups because they supervised or worked on a large partnership  return audit, based on our definition of large partnerships above, which  was closed in calendar year 2013. Where available, we supplemented the  challenges identified in these focus groups with supporting data and  documentation to provide context or support those challenges identified.  We performed a content analysis on the six focus groups, using NVivo  software, to analyze and categorize the themes of the focus groups. The  results of the focus group data are not generalizable to all IRS audits and  do not necessarily represent the official viewpoint of IRS. Instead the  results are used to identify themes in conjunction with the other data we  collected. We compared information available to the intent of the   In addition, we  partnership audit procedures outlined in statute.compared information available on audits of large partnership returns to  Standards for Internal Control in the Federal Government  (GAO/AIMD-00-21.3.1, November 1999).
To identify and assess IRS efforts to address the challenges of audits of  large partnership returns, we reviewed IRS documentation and  interviewed IRS officials to identify any efforts and initiatives they have  ongoing related to large partnership. We assessed IRS’s efforts and  initiatives related to large partnerships using project planning criteria that  our prior work identified work as leading practices. We identified these  criteria by conducting a literature review of a number of guides on project  management and business process reengineering.
For the purposes of this review, we determined that the data used in our  analysis were sufficiently reliable for our purposes and all dollar values  have been adjusted for inflation to tax year or fiscal year 2014. Our data  reliability assessment included reviewing relevant documentation,  conducting interviews with knowledgeable IRS officials, and conducting  electronic testing of the data to identify obvious errors or outliers. All  Statistics of Income estimates in this report have 95 percent confidence  intervals that are within +/- 10 percent of the point estimate, unless  otherwise specified. Based on IRS documents and interviews with IRS  officials, data in the ELPI file may be incomplete since this file is based on  Schedule K-1 data. For example, some Schedule K-1s may be missing  from the database because partnerships did not file Schedule K-1s, IRS  errors, and timing problems. In general, the depth of tiering in ELPI for a  partnership structure represents a minimum amount resulting in  approximate entity counts because the missing data would add more  entities that qualify for our definition of large partnerships.
We conducted this performance audit from October 2013 to September  2014 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.
section_title: Appendix II: Additional Data on Number and Characteristics of Large Partnerships
subsections: section_title: Average and Median Number of Direct Partners Average Median Average and Median Number of Direct and Indirect Partners Average Median
section_title: Number of Direct and Indirect Partners 100 to 500 928 501 to 1,000 366 1,001 to 2,500 371 2,501 to 10,000 725 10,001 to 100,000 384 100,001 to 500,000 57 501,000 or more d
paragraphs: Legend: d = Value not shown to avoid disclosure of information about specific taxpayers.
section_title: Number of Direct Partners 0 to 99 100 to 500 501 to 1,000 1,001 to 2,500 2,501 to 10,000 10,001 to 100,000 100,001 to 500,000 501,000 or more
paragraphs: Legend: d = Value not shown to avoid disclosure of information about specific taxpayers.
section_title: Average Asset Size Asset Size $100 million but less than $250 million $250 million but less than $500 million $500 million but less than $1 billion $1 billion but less than $5 billion $5 billion or more
paragraphs: Legend: d = Value not shown to avoid disclosure of information about specific taxpayers.
section_title: Industry Group Mining Manufacturing Transportation and Warehousing Finance and Insurance Real Estate, Rental, and Leasing Professional, Scientific, and Technical Services Holding Companies Other
section_title: Appendix III: Data on Audits of Large Partnerships and Large Corporate Returns
paragraphs: Legend: d = Value not shown to avoid disclosure of information about specific taxpayers.
Calendar year 2012 partnership filings were not available at the time we completed our analysis to  determine the audit coverage rate for fiscal year 2013.
subsections: section_title: Asset Size $100 million or more $100 million but less than $250 million $250 million but less than $1 billion $1 billion or more
paragraphs: Legend: d = Value not shown to avoid disclosure of information about specific taxpayers.
section_title: Asset Size $100 million or more $100 million but less than $250 million $250 million but less than $500 million $500 million but less than $1 billion $1 billion but less than $5 billion $5 billion but less than $20 billion $20 billion or more
paragraphs: For the audit coverage rate calculation for fiscal year 2012, we combine correspondence audits  (audits completed by mail) and field audits in the calculations for the highest two asset brackets as  the IRS Data Book does not report the number of field audits separately to avoid disclosure of  information about specific taxpayers.
section_title: Asset Size $100 million or more $100 million but less than $250 million $250 million but less than $500 million $500 million but less than $1 billion $1 billion but less than $5 billion $5 billion but less than $20 billion $20 billion or more
section_title: Appendix IV: Comments from the Internal Revenue Service
section_title: Appendix V: GAO Contact and Staff Acknowledgements
subsections: section_title: GAO Contact
section_title: Staff Acknowledgements
paragraphs: In addition to the contact listed above, Tom Short, Assistant Director; Vida  Awumey; Sara Daleski; Deirdre Duffy; Robert Robinson; Cynthia  Saunders; Erik Shive; Albert Sim; A.J. Stephens; and Jason Vassilicos  made key contributions to this report.