Tax Analysts Blog

Audit Electability

Posted on Apr 7, 2014
In an ideal world, tax laws do not drive business decisions. Instead, the tax system should accurately reflect how businesses operate and then capture the proper amount of revenue for the government. That was one of the main selling points for the check-the-box regulations. However, a taxpayer’s choice of entity can have broad tax ramifications, including some consequences unintended even by the complicated U.S. tax regime.

According to Tax Analysts’ Amy Elliott, taxpayers can essentially elect to make themselves immune to IRS audits by choosing to operate as large, widely held partnerships. In a short video, Tax Analysts explains why the IRS has trouble auditing large partnerships, particularly those that are publicly traded and whose members might be partnerships themselves. In her second article on the topic, Elliott explains that the problem is caused by the interaction of TEFRA’s elaborate examination rules and limited IRS resources. Complying with TEFRA’s provisions by sending notices to all the partners of a widely held partnership is simply beyond the IRS’s means, according to Elliott. “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,” she writes.

In 1990 the IRS admitted that it could not audit widely held partnerships (“Widely Held Partnerships: Compliance and Administration Issues, A Report to the Congress,” March 1990), and that was before these types of entities exploded in popularity, particularly in the energy and financial sectors. Faris Fink, the former IRS Small Business/Self-Employed Division commissioner, said last year that “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.”

Passthrough entities have always been the elephant in the room during discussions of tax reform. Subchapter K and S entities are not solely tax evasion vehicles by any means, but passthrough rules are slapdash, and the last major reform occurred 30 years ago and made the system worse. Corporations are better audited (many large corporations are under continuous audit) and easier for the IRS and Congress to deal with. That’s why there’s so much talk about corporate tax reform on Capitol Hill despite the fact that 17 percent of the returns processed by LB&I are from corporations, compared with 50 percent from partnerships.

But passthrough taxation is finally starting to attract some attention. The Obama administration has floated the idea of taxing large passthroughs as corporations, and Elliott discusses how House Ways and Means Chair Dave Camp’s comprehensive discussion draft would deal with the partnership audit problem. Camp also made an honest effort to avoid having passthrough entities pay for corporate rate cuts. (This is an underreported issue. Most of the pay-fors frequently bandied about to pay for a lower corporate rate would harm S corporations and partnerships, neither of which would derive any benefit from a lower corporate rate.) The reality is that the IRS’s partnership problem is just one example of how the creaky U.S. tax system is struggling to deal with the modern economy and the changing business world.

The IRS’s inability to adequately audit partnerships essentially means that taxpayers can elect whether to be examined or not by their choice of entity. The check-the-box rules make it even easier to organize into whatever form of business a taxpayer desires. Even if the government should allow taxpayers to freely decide on disregarded status, it certainly shouldn’t make audits electable.

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