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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. Legend: d = Value not shown to avoid disclosure of information about specific taxpayers. Legend: d = Value not shown to avoid disclosure of information about specific taxpayers. Legend: d = Value not shown to avoid disclosure of information about specific taxpayers. 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. Legend: d = Value not shown to avoid disclosure of information about specific taxpayers. 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. 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.

Summary: 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. 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. 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.