By Amy S. Elliott -- firstname.lastname@example.org
Most of us have a moment when filing our annual tax returns when we consider the possibility that the IRS might question us about them. The IRS can audit taxpayers, and that audit could lead to additional taxes, interest, and penalties.
But there are some people -- many of whom happen to be very wealthy -- who don't have that same fear (watch this short Tax Analysts video explaining why: https://www.youtube.com/watch?v=roTrgcD_n9g&feature=youtu.be. Video transcript can be found here). Those taxpayers have income from entities that are treated as partnerships for tax purposes. There are some partnerships -- those that have lots and lots of partners and are referred to as widely held partnerships -- that pose an audit challenge for the IRS.
While the IRS might technically be able to audit widely held partnerships (depending on your definition of audit and widely held), the exams have no teeth because the agency has a limited capacity to issue the partners notices of computational adjustment. (Prior analysis: Tax Notes, July 23, 2012, p. 351.)
In many cases, before issuing the partner-level notices, the IRS has to manually pull the returns of tens and sometimes hundreds of thousands of partners -- a process officials have generally decided isn't worth the time or expense to bother with or improve upon. Believing their businesses are essentially audit proof, some partners don't worry that the IRS might question the hundreds of billions of dollars' worth of items claimed on their returns.
Many private equity firms, oil and gas partnerships, and hedge funds are set up as widely held partnerships. Some of them are publicly traded so that an individual can become a partner by simply going to his broker and paying $20 to $40 for a unit of the Blackstone Group LP, the Carlyle Group LP, or KKR & Co. LP. These three public firms would be treated as corporations if not for an exception in the tax code that allows them to avoid corporate-level tax on the bulk of their income. (Prior coverage: Tax Notes, June 25, 2007, p. 1235.)
Investment firms continue to find this structure -- which not only provides some protection from audit but also offers the ability to go public like a C corporation while avoiding corporate-level tax -- appealing. Ares Management LP, a private equity firm with about $74 billion of assets under management, filed its initial public offering paperwork (Form S-1) March 31 with the SEC.
The partnership audit issue poses a serious enough threat to our tax system that House Ways and Means Committee Chair Dave Camp, R-Mich., has proposed a fix.
Congress Is Starting to Listen
Right now, the largest C corporations in the United States are under constant IRS scrutiny. But some widely held partnerships that could be in the same business as their corporate counterparts don't get the same level of audit attention. Camp wants to ensure that business owners don't consider audit risk in their choice of entity calculus.
A problem needs to get very bad before it attracts congressional attention. That is especially true if some of the people who benefit from the problem -- the investment fund managers who don't have to worry about IRS adjustments to their partnership items -- are some of the biggest campaign contributors for both parties.
Camp released a comprehensive tax reform draft on February 26 that not only proposed to tax the profits interests of hedge fund and private equity firm managers at ordinary income rates, but also contained a proposal to simplify the way that partnerships are audited.
Camp wants to repeal the audit rules that apply to partnerships with more than 10 partners (sections 6221 through 6231, which came about as part of the 1982 Tax Equity and Fiscal Responsibility Act). His new regime would allow the IRS to essentially audit all partnerships like corporations.
Partnerships having 100 or fewer partners (none of which are partnerships) would be permitted to elect out. But given that most partnerships would probably prefer not to have to issue amended Schedules K-1 (and most partners don't want to have to file amended returns), there's a good chance few partnerships will elect out.
Like TEFRA, Camp's new audit regime would require the IRS to audit partnerships at the entity level to determine whether adjustments are needed for partnership-level items of income and deduction, etc. But unlike TEFRA, it would force the partnership (not the partners) to pay any tax due, imposing joint and several liability on it and the partners for any imputed underpayment.
The TEFRA rules provide numerous safeguards to ensure that partners are notified of, and given limited ability to participate in, the audit, but the requirements are a serious handicap to the IRS in widely held partnership audits. Camp's plan removes the right of partners to participate in audits. It takes some of the burden of protecting partner rights off the IRS and shifts it to partnerships, which already have a fiduciary duty to their partners under state law, and may add indemnification provisions to partnership agreements if this new audit regime becomes law.
Details of Camp's Solution
Under the current rules, if the IRS audits a more-than-10-partner partnership and identifies a partnership-level error affecting items flowed through to the partners, it's the IRS's responsibility to calculate how that error would affect each individual partner in the year under audit and issue the partners notices of adjustment (Letter 4735, "Notice of Computational Adjustment"). When the partnership has a very large number of partners, the IRS almost never bothers. Sometimes the partnership asks to settle the matter at the partnership level, as described below.
Under Camp's proposed audit regime, if the IRS finds that the partnership got one or more of its items wrong, it can simply net the item adjustments, multiply that amount by the highest tax rate (either on individuals or corporations) in effect for the year under exam (what Camp calls the reviewed year), and send the partnership a notice for the imputed tax. Imputed overpayments reduce the partnership's income in the adjustment year. The regime allows a partnership to request an adjustment under the new rules if it finds an error but doesn't want to issue amended Schedules K-1.
Camp would preserve and expand IRS math error authority to compel consistent reporting. When a partner reports a partnership item differently from the partnership to reduce his tax liability, the IRS would have math error authority to assess the partner's liability without following the usual procedures that allow partners to dispute the adjustment in the Tax Court.
If a partner doesn't think he's getting a fair shake from this imputed overpayment rule, he would be able to file an amended return reflecting his share of the adjustment and paying any additional tax owed, taking into account his own tax situation. The imputed partnership tax liability would then be reduced by that partner's share of the adjustment. If the adjustment merely changes the allocation of items among the partners, this provision wouldn't apply unless every partner affected by the misallocation files an amended return. All this must happen within 180 days of the notice of the proposed partnership adjustment.
Camp's plan would provide that the IRS must notify only the partnership and its representative of the proposed adjustment 180 days before it becomes final. If partners want to go the amended return route, the plan assumes that a partnership will issue amended Schedules K-1 quickly enough to allow them to do that. Partnerships can dispute the adjustments in the Tax Court provided they file the petition within 90 days of receiving the notice of a final partnership adjustment.
Camp's new audit regime doesn't have the partnership-level withholding component contained in his previous draft. That draft proposed a unified passthrough regime under which a percentage of the owner's distributive share of passthrough income would be withheld at the entity level. The withholding requirement, along with limitations on special allocations, was an attempt to address the IRS's challenge in auditing complicated partnerships. (Prior coverage: Tax Notes, Apr. 8, 2013, p. 115.)
Still, Camp's current proposal would revolutionize how the IRS audits partnerships and have a far-reaching effect on all sorts of businesses. "Most practitioners agree that the IRS partnership audit procedures need to be modified as the TEFRA rules are complex and can be administratively burdensome to both the taxpayer and the IRS," said Miri Abrams Forster of Rothstein Kass.
"If the proposal moves forward, it would impact discussions regarding choice of business entity as well as the decision of when to become a partner," Forster said. "Since exam adjustments would affect current partners, it would be important to perform sufficient due diligence on the status of any pending IRS examinations to try and assess when resolution might be expected and its potential impact prior to making an investment."
Camp's partnership audit proposal would net the government an additional $13.4 billion in revenue over 10 years, according to the Joint Committee on Taxation score (JCX-20-14).
The Obama administration first proposed addressing the problem in its fiscal 2013 budget. It would have imposed a new audit regime, the required large partnership regime, on partnerships with at least 1,000 partners. Some services partnerships -- like law and accounting firms -- would have been exempt.
President Obama's required large partnership regime (which would only net the government an additional $1.8 billion in revenue over 10 years) would expand the current electing large partnership (ELP) regime, which gives the IRS the authority to flow through any adjustments to the current partners (or the partnership could elect to pay any adjustment itself). The problem has been that few partnerships elect into ELP.
In 2011 only 105 partnerships filed a Form 1065-B, "U.S. Return of Income for Electing Large Partnerships," which was down from 109 in 2009. Those 105 partnerships had, on average, 27,929 direct partners and, on average, $11.6 billion in total assets. (For "Partnership Returns, 2011" by Ron DeCarlo, Lauren Lee, and Nina Shumofsky, see IRS Statistics of Income Bulletin 33, Fall 2013, http://www.irs.gov/pub/irs-soi/13pafallbulpartret.pdf. For "Partnership Returns, 2009" by Nina Shumofsky and Lauren Lee, see SOI Bulletin 31, Fall 2011, http://www.irs.gov/pub/irs-soi/11pafallbulpartret.pdf.)
When Camp released his partnership audit proposal, he drew no special attention to it. Obama did the same with his partnership audit proposal. And the IRS Large Business and International Division is trying hard not to talk. Telling taxpayers that the IRS can't audit them won't encourage compliance.
But the lack of attention to the problem doesn't mean it isn't serious. When asked why Camp believed it was necessary to include the partnership audit proposal in his tax reform draft, Ways and Means staff told Tax Analysts that the proposal "grew out of extensive discussions with a whole range of stakeholders and other evidence indicating that current law is just not an effective tool for the IRS to ensure tax compliance by large complex partnerships."
Tax Analysts has conducted its own comprehensive discussions with stakeholders confirming the widely held suspicion that partnership-level adjustments aren't flowed through to the ultimate partners of the largest widely held partnerships. That's not to say that there isn't audit activity in the area, even affecting publicly traded partnerships (PTPs), the largest of which has nearly 250,000 unitholders.
Most PTPs do business in the energy and natural resources industry. About 130 energy PTPs exist, and as of September 2013, their market capitalization was about $422 billion.
PTPs in the financial industry make up only about 10 percent ($49 billion) of all PTPs by market capitalization. But partnerships can easily be widely held without being publicly traded. It isn't uncommon for businesses to set up structures involving tiers of partnerships, magnifying the number of partners.
Camp would restrict the use of PTPs treated as partnerships for federal tax purposes to entities that derive 90 percent of their gross income from mining and natural resources. Interest, dividends, real property rents, and gain from the sale of real property would not be qualifying income. Investment fund PTPs would be treated as corporations for tax purposes.
Whether a partnership has something to hide from the IRS -- gray areas or outright abuses -- the difficulty in auditing puts the IRS in an impossible position, giving it no leverage over the entity. (Prior analysis: Tax Notes, Aug. 12, 2013, p. 639.)
IRS Audit Efforts
This problem would be very expensive for the IRS to solve absent a change in the law, which is why the proposed statutory fixes from lawmakers are encouraging. Ideally, all of the necessary information from tax returns, Schedules K-1, and partnership agreements would be available electronically and could be matched and adjusted at the touch of a button. But it isn't.
The IRS -- and widely held partnerships, for that matter -- has enough trouble trying to determine the number and identity of the ultimate partners for the reviewed year. In the past, it used its YK1 Readiness/Link Analysis tool, which graphically displays how various flow-through entities are connected to identify the ultimate beneficiaries, to screen out returns for which the ultimate number of partners was so great that the adjustments would be too diluted to be worth the audit.
In a statement to Tax Analysts, the IRS said it "has developed and is using new data tools that help us identify the connections among entities within a single partnership structure as well as across related partnerships . . . [and] identify the total ownership interests of each entity, even when those interests are dispersed across several tiers."
But the IRS said that even though it can identify the ultimate indirect owners of a partnership, it does "not collect information about indirect partners." So, for instance, it couldn't answer how many partnerships would be affected by Obama's required large partnership proposal.
In 2009 LB&I formed a global high-wealth industry group, which has had the effect of putting more partnerships under the Service's audit microscope. The group is focused on individuals (and the entities that they control) with assets or earnings of tens of millions of dollars. When the IRS audits the managers of investment partnerships as part of the high-net-worth effort, it has to audit their partnerships as well. (Prior coverage: Tax Notes, Apr. 16, 2012, p. 260.)
An IRS auditor may ask questions of a widely held partnership. Sometimes that happens by way of draft information document requests so that the auditor can delay issuing the notice of beginning of administrative proceeding, only to withdraw it within 45 days. The withdrawal allows the IRS and the partnership to avoid the TEFRA partner notification requirements (not to mention the disclosure requirement the partnership might have under SEC rules), but both the agent and the partnership get credit for the audit, so the partnership can adjust its financial statement tax reserves.
On a partnership audit, the parties sometimes attempt to settle the case at the partnership level. "In a TEFRA partnership examination, the partnership may decide that it wants to pay all taxes due as a result of exam adjustments on behalf of its partners/investors," Forster explained. "It is the partnership that requests to make payment on behalf of its partners, but it is not required by either side."
That settlement would have to take the form of a closing agreement, which would have to be approved by the IRS Office of Chief Counsel. "This additional level of coordination can add to the time needed to close out an examination and may be difficult to complete within the applicable assessment statute," said Forster. "For the above reasons and others, the IRS may prefer to have the adjustments directly assessed to the partners rather than work through a closing agreement."
On March 21 the IRS disclosed that in fiscal 2013, it audited 10 percent of individual tax returns reporting $1 million or more in adjusted gross income filed in calendar year 2012. Returns in that income bracket represented 0.21 percent of all returns filed that year. (See 2013 IRS Data Book, Table 9b, http://www.irs.gov/file_source/pub/irs-soi/13db09bex.xls.)
But the partnership audit challenge gets bigger with every passing year. The most recent IRS Statistics of Income division data show that the number of very large businesses organized as partnerships is growing. According to SOI estimates, in 2009 there were 18,542 partnerships -- compared with 23,761 corporations -- with at least $100 million in balance sheet assets. In 2011 the number of very large partnerships grew to 20,678, compared with 24,983 corporations.
In fiscal 2013, the IRS audited only 14,870 partnership returns, representing 0.4 percent of the total partnership returns filed the previous year, and a whopping 44 percent of those audits were closed with no change.
The comparable audit rate for corporations (excepting subchapter S entities) was 1.4 percent, although the IRS audited 91.2 percent of the 444 corporations with at least $20 billion in balance sheet assets. Auditing those 405 big corporations netted the government about $8.6 billion in additional assessments. (See 2013 IRS Data Book, Table 9a, http://www.irs.gov/file_source/pub/irs-soi/13db09aex.xls.)
While the IRS doesn't break down its partnership audit statistics by size (either asset class or number of partners), it's likely that it doesn't come close to 90 percent of partnerships with at least $20 billion in balance sheet assets. The IRS won't reveal the number that it audits. Could it be so small that its disclosure is prohibited under the section 6103 taxpayer identity protection rules?
The IRS should be focused on doing all it can to improve its audit coverage of widely held partnerships. According to the IRS, only 17 percent of LB&I's returns processed in 2012 were from C corporations (50 percent were partnerships). But its agents are largely focused on subchapter C tax law, not subchapter K or S. They need to be retrained.
Faris Fink, the former IRS Small Business/Self-Employed Division commissioner, said in November that SB/SE's top exam priority is its passthrough strategy, which it's working on with LB&I. (SB/SE has jurisdiction over some aspects of TEFRA, despite the size of the entity.)
"Over the years . . . we've seen a tremendous increase in flow-through entities, and particularly partnerships. And the fact of the matter is between 2007 and 2011, partnerships grew by 15.3 percent." Fink said. He has since retired from the IRS.
"The Service had for a long time focused its energy on corporations. Frankly, we're a little bit behind the curve on getting around to developing the partnership strategy and being involved in the partnership strategy," Fink said, speaking at the American Institute of Certified Public Accountants National Tax Conference in National Harbor, Md.
When asked at the Tax Executives Institute's midyear conference on March 25 whether the IRS thinks it's important to improve its audit coverage of widely held partnerships or whether it believes widely held partnerships don't pose a compliance risk, LB&I division counsel Linda Kroening said, "I certainly don't think we've made any decisions around whether or not they may pose a compliance risk."
"The Service across the board tries to have coverage . . . across categories, across entities. I don't know what the current LB&I coverage rates are" regarding widely held partnerships, said Kroening.
The IRS told Tax Analysts that it's "well aware of the growing use of passthrough entities, and across the IRS, to meet this development, partnerships have received greater scrutiny." But it added that because it has limited resources and because some large partnership structures are complex, it's important to risk-assess them. "While the use of partnerships has grown substantially, not all of these entities, even very large ones, pose the same compliance risk," it said.
The IRS told Congress 24 years ago that its inability to audit widely held partnerships may be causing "significant loss of revenue to the government." Even if the IRS can't be open with taxpayers about this enforcement weakness, it should reveal the breadth and depth of the problem to the president, Treasury, and any lawmakers who bother to inquire so that Congress doesn't take another 24 years to respond to its call for help.
Lee A. Sheppard contributed to this article.