Partnerships group two or more individuals or entities—such as corporations or other partnerships—to carry on a business. Individuals, corporations, trusts, estates, tax-exempt entities, and other partnerships may all be partners. S corporations may have between 1 and 100 shareholders. Individuals, certain trusts, estates, and certain tax-exempt entities may be S corporation shareholders. Partnerships and S corporations must file tax returns (IRS Forms 1065 and 1120-S, respectively). Partnerships and S corporations differ from C corporations—which are covered by subchapter C of the Internal Revenue Code and include nearly all publicly traded corporations—in that C corporations pay corporate income tax on their profits. Partnerships and S corporations do not directly pay taxes on the net income reported on Forms 1065 or 1120- S. Instead, they pass profits to partners and shareholders, respectively, who pay any applicable taxes. In recent decades, partnership and S corporation activity has represented a growing share of business activity, while the share of C corporation activity has declined, as measured by gross business receipts, the revenue that a business receives from its trade or operations before subtracting expenses and deductions. As a result, a larger share of business activity is now subject to taxation at the individual, rather than the corporate level, than in the past. According to IRS statistics compiled for tax year 1980 through tax year 2008, the percentage of business receipts taken in by partnerships and S corporations grew from about 7 percent to about 34 percent, as shown in figure 1. There were about 4 million S corporations and 3 million partnerships in the United States in tax year 2008. However, the bulk of flow-through business activity was concentrated in a smaller number of entities. In the case of partnerships, 95 percent of business receipts in tax year 2008 went to the 260,000 partnerships with receipts of $1 million or more (see figure 2). Partnerships and S corporations are required to send each of their partners and shareholders a Schedule K-1 that reports how much income or loss they allocated to that partner or shareholder in the past year, and to send a copy to IRS. Individuals and business entities to which partnerships and S corporations allocated income are required to report that income on their income tax returns. IRS has multiple compliance assurance processes. Two important ones for detecting misreporting of partnership and S corporation income are examinations (commonly known as audits) and K-1 matching. Examinations are IRS reviews of an entity’s or individual’s books and records conducted to verify what is reported on a tax return. They can be labor intensive and time consuming for IRS, but can detect complicated forms of noncompliance. IRS may examine a flow-through entity, the partners or shareholders (such as individuals) who are allocated income from the flow-through, or—if the entity is part of tiered structure of related entities—IRS may examine the entire tiered network. The examination process generally occurs in three steps. Typically, it starts with return selection—a largely automated process that selects tax returns for further review if they appear to be at risk for noncompliance. In the next step—classification—trained staff look at the selected tax returns and determine whether they warrant an examination, what issues should be examined, and how the examination should be conducted. In the final step—examination—a more detailed review of the return and other relevant information IRS possesses, such as information returns (for example, K-1s), is conducted. The examination generally includes contact with the taxpayer and a review of the taxpayer’s books and records. It ends with a decision about whether to recommend no change, a refund, or additional tax assessment. K-1 matching is a function of IRS’s Automated Underreporter (AUR) program (see figure 3 for a description of the AUR process). AUR matches the information returns that IRS receives about a taxpayer with income reported on that taxpayer’s Form 1040. Information returns are documents, such as W-2s (used to report wages) and K-1s, that third parties provide to taxpayers and IRS about taxpayers’ income. K-1 matching aims to detect mismatches between each taxpayer’s Form 1040 and K-1s, allowing IRS to detect taxpayers who misreport income from partnerships and S corporations. Because taxpayers know that IRS receives a copy of each K-1, matching encourages voluntary compliance K-1 matching of individual returns is not designed at the taxpayer level.to detect misreporting about business operations at the flow-through entity level. Additionally, it does not match partnership and S corporation returns with the K-1s they receive from other flow-through entities. There is substantial uncertainty surrounding the extent of income misreporting by partnerships and S corporations themselves, and by the individual taxpayers to whom the income is allocated. IRS has estimated misreporting by S corporations but not by partnerships. In IRS’s most recent study of S corporation misreporting— covering tax years 2003 and 2004—IRS conducted detailed examinations of a sample of S corporation tax returns. However, such a study inevitably cannot detect all misreporting. IRS analysis of the study did not include an adjustment for income that examiners were unable to detect, so the true amount of misreporting by S corporations may have been significantly larger than IRS reported, according to a preliminary report by an official from IRS’s Office of Research, Analysis, and Statistics. For those two years, using a weighted average, IRS estimated that S corporations misreported about $55 billion per year in net income. Because IRS has not conducted a similar study of partnerships since 1988, and does not have plans to conduct one, it does not have a similar estimate for partnerships. Moreover, estimating total partnership income or loss and the misreported amounts of income and loss is complicated by the fact that substantial portions of those amounts get double counted as they pass from one partnership to another. 2011, partnerships reported a total of $1,468 billion of income and $507 billion in losses. About 31 percent of this income and 36 percent of the losses were allocated to other partnerships before ultimately being passed on to another party, resulting in double counting of this income and losses. Partnerships may also allocate income to others, including S corporations, estates, and trusts, which would complicate correcting for double counting. About 31 percent of partnerships were part of multitiered networks in tax year 2011, as shown in figure 4. See appendix II for more information on tiering of flow-through networks. Throughout this report, we use the term double counted to refer to items that are counted two or more times (not necessarily exactly two times). A simple network is a network that includes a flow-through entity that does not receive allocations from another flow-through entity nor allocate income to another flow-through entity. A multitiered network includes at least one flow-through entity that allocates income to another flow-through entity. Because the database containing the data this figure is based on has incomplete data, the extent of tiering presented in this figure represents a minimum amount, and counts are approximate. Numbers do not sum to total, and dividing entity counts by totals do not match up with percentages, due to rounding. Without a strategy for better estimating the extent and nature of partnership misreporting, IRS cannot make fully informed decisions on how to allocate resources across enforcement programs and across different types of business entities and taxpayers. IRS’s strategic plan for 2009-2013 calls for IRS to develop improved research-driven methods and tools to detect and combat noncompliance and improve resource allocation. As we discussed in a 2012 report, optimizing resource allocation has the potential to bring in substantially more enforcement revenue. IRS’s compliance research studies have produced data on flow-through income misreporting by individual taxpayers. Using this information, and considering various caveats and uncertainties, we estimated a rough order of magnitude of the misreporting to be $91 billion per year for tax years 2006 through 2009. This estimate does not cover all flow-through income. Only some types of income—ordinary business income, rental income, and guaranteed payments—can be included in an estimate of income that individuals misreported from partnerships and S corporations. These items are reported on a section of the individual tax return specific to income from partnerships and S corporations. Some other types of income individuals receive via partnerships and S corporations, including interest, dividends, and royalties, cannot be estimated based on available data because they are combined with the same types of income from nonflow-through sources on another part of the individual tax return. Additionally, there is uncertainty surrounding any estimate of how much income individual taxpayers misreported due to presumed misreporting that IRS research examiners are inevitably unable to detect. IRS assumes that such misreporting exists and adjusts its estimates to account for it when it does its compliance studies on individual taxpayers. For individual taxpayers, an estimate of the rate of partnerships’ and S corporations’ misreporting of their own income can be incorporated into the adjustment, since errors at the entity level would generally be passed through to individual taxpayers. The individual misreporting rate would be expected to be at least as high as the misreporting rate for the entities that are allocating income to them. However, as mentioned above, IRS’s most recent estimate of S corporation misreporting is itself uncertain, and IRS does not have a similar estimate for partnerships. With these caveats in mind, we estimated, based on IRS research examination data, that in tax years 2006 through 2009, the annual average income that individual taxpayers were allocated from partnerships and S corporations was $517 billion, and annual average losses were $94 billion, for a net of $423 billion. Of this $423 billion, we estimated that individual taxpayers misreported about $91 billion per year (this amount includes understated income plus overstated losses, less overstated income and understated losses).