IRS Auditors Place More Focus On Partnerships As Use Of The Entity Increases

IRS officials, including Faris Fink, then Commissioner of the Small Business and Self-Employed Division, announced in 2013 that the IRS would increase its scrutiny of partnership entities. Indeed, the IRS’s audit statistics for 2014 have shown that Fink’s prediction was accurate. While the overall audit rate for all types of businesses fell from 0.61 percent in Fiscal Year (FY) 2013 to 0.57 percent for FY 2014, the audit rate for partnerships has increased.

The IRS’s recently released Winter 2015 Statistics of Income Bulletin underscores why IRS officials are becoming increasingly concerned about partnerships. The bulletin-which highlights several trends including partnership numbers-shows that the number of partnerships has been growing recently by 3.1 percent, year over year. Not only this, but the number of partners, the level of assets, and the total gross receipts received during this period all increased.

Passthrough entities like limited partnerships and limited liability companies (LLCs) have become an increasingly popular way of organizing businesses. (The IRS reported that domestic limited liability companies (LLCs) made up 65.3 percent of all partnerships.) Domestic limited partnerships-although representing only 12 percent of all partnerships-but reported 33.4 percent of all partnership profits (the largest figure of all types of partnership entities and the largest share of partners.

While incorporation was once the only means of shielding individual directors and officers from individual liability for the corporation’s obligations, passthrough entities can now be structured in such a way as to protect the individual partners from liability for the company’s debts. In addition, passthrough entities like partnerships can still enjoy the benefits of passthrough taxation. Corporations, on the other hand, are generally taxed twice: once at the entity level, and again when profits are distributed to the individual shareholders. S corporations are the exception there, being taxed only once at the owner/shareholder level and sharing many similarities with partnerships.

Partnership Statistics

The IRS’s Winter Statistics of Income Bulletin reported that the number of partnerships filing tax returns grew 3.1 percent (from 3,285,177 to 3,388,561) between 2011 and 2012. Since 2003, the number of partnerships has grown at an average annual rate of 3.9 percent. The Bulletin also reported that the number of partners has grown during each of the last nine years, increasing 3.9 percent (from 24,389,807 to 25,333,616) between 2011 and 2012. Partnerships with fewer than three partners made up more than half (55.9 percent) of all partnerships, the IRS reported. Partnerships with 100 or more partners, however, accounted for almost half (47.3 percent) of all partners in 2012.

For 2012, partnerships passed through $1,400.8 billion in total income minus total deductions available for allocation to their partners, the Bulletin reported. This amount represents a 43.4-percent increase from 2011 when partnerships passed through $976.9 billion. In contrast with Tax Year 2011, when individual partners received the largest portion of passthrough income, partners classified as partnerships received the largest portion of this income for 2012.

Need for Partnership Audit Reform

Tax administrators, including IRS Commissioner John Koskinen, have expressed concern that this growth in more profitable, more complex partnerships has created a dire need for reform of the current rules for auditing partnerships. The rules, they say, were legislated before partnerships became so complex, administrators say, and now the obstacles to the IRS’s efficient oversight of large partnerships in particular leaves room for a large tax compliance gap. For example, a report issued in September 2014 by the Government Accountability Office (GAO) revealed that the IRS’s field audit rate of large partnerships-defined by the GAO as having $100 million or more in assets and 100 or more direct and indirect partners-was less than one percent for FY 2012.

Several lawmakers, including President Obama, Rep. Dave Camp, R-Mich., and Sen. Carl Levin, D-Mich., have issued tax reform proposals that include changes for audits of partnership entities, but most of these have fallen flat in the debating room. Thus, the IRS is doing what it can without Congressional help, IRS officials stated during a recent tax law conference in Washington, D.C. Nancy Knapp, Associate Area Counsel, IRS Large Business & International Division (LB&I), stated that the IRS planned to increase audits of passthrough entities in the future. This increased focus, she said, stemmed from the IRS’s recognition that an estimated 191,000 of 296,000 L&I taxpayers are passthrough entities that generate revenue the IRS has up until now practically ignored.

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