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.