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. 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. 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. 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. We provided a draft of this testimony to IRS for comment. IRS provided technical comments, which were incorporated, as appropriate. 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. This is a work of the U.S. government and is not subject to copyright protection in the United States. The published product may be reproduced and distributed in its entirety without further permission from GAO. However, because this work may contain copyrighted images or other material, permission from the copyright holder may be necessary if you wish to reproduce this material separately.

Summary: 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. 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. 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.