Large Partnerships Should Prepare Now for New IRS Enforcement

While it will take years for the IRS to hire enough staff to fully enforce new compliance efforts targeting partnerships and wealthy taxpayers, large partnerships should be aware of the greater federal scrutiny on the horizon.

The IRS said it will send compliance letters to 500 partnerships with more than $10 million in assets and balance sheet discrepancies. The number of discrepancies between year-end and beginning-year balances has been increasing, and many taxpayers aren’t attaching the required statements explaining the differences. The IRS will follow up if there are discrepancies and may audit the partnerships depending on the response.

It also is opening audits of 75 of the largest partnerships in the US, including hedge funds, real estate investment partnerships. and publicly traded partnerships that average $10 billion in assets. The agency said it used artificial intelligence to help choose returns to audit under the large partnership compliance program and will use that technology to identify potential compliance risks in partnerships.

An IRS audit likely will start with partnership’s ordinary business income or loss. In that respect, a partnership audit is like a C corporation audit and will focus on items such as substantiation of business expenses.

However, the more complex issues are between the partners and the partnership, such as disguised sales, distributions in excess of basis, and special allocations. As agents become trained in partnership tax provisions, audits will focus on these more complex issues. If the IRS identifies widespread problems, steps can then be taken to address those issues through legislation.

If selected for an audit, many partnerships will be subject to procedurally complex partnership audit rules. Under these rules, the default is that the partnership pays an entity-level tax—called an imputed underpayment—on any adjustments. This means that unless certain steps are taken, the current partners would bear the tax even if they weren’t partners for the year under audit.

To navigate these procedurally complex rules and ensure the correct tax is paid by the correct partners, the partnership and its representative must make a number of time-sensitive strategic decisions. They’ll want to coordinate with counsel as they navigate this complex new regime and the IRS’s new enforcement efforts.

This new effort expands the IRS’s recent increased focus on partnerships, following years of historically low audit rates. In the past, the IRS hasn’t been good at identifying partnership returns with noncompliance. The US Government Accountability Office found that the IRS audited only 54 of 20,052 large partnerships in the 2019 tax year—a rate of only 0.3%.

The GAO report also said large partnerships—defined as those with at least $100 million in assets and 100 partners—grew 600% between 2002 and 2019. This growth is due to changes in state laws governing business entities, the check-the-box regulations allowing entities to choose how they are taxed, and rising corporate tax rates before the 2017 tax law changes.

The IRS now has the funds to devote more resources to auditing large partnerships. The agency is hiring more than 3,700 people nationwide to assist, and work by a special group in the Large Business and International Division to focus exclusively on large and complex pass-through entities will formally start late next year. The IRS’s strategic plan is ambitious and can only work if the applicant pool is there and the training is done. So it will take time.

The IRS also will need time to staff up and train agents in the area of the tax law that many practitioners view as the most complex. It needs to get these early steps right to have the expertise to audit partnership returns successfully. Further, it will take several years to evaluate whether AI and other tools help the IRS get better at selecting partnership returns for audit.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Mary McNulty is a tax partner in Holland & Knight’s Dallas office. She represents large business taxpayers in IRS audits, appeals, and tax litigation.

Lee Meyercord is a tax partner in Holland & Knight’s Dallas office. She has significant expertise in partnership tax issues relating to energy, real estate, and private equity.

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