With more businesses organizing themselves as partnerships, IRS needs to enhance audit efficiency, suggests a new GAO report.

United States Government Accountability Office in its September 2014 report on “Large Partnerships” has recommended that the IRS take multiple actions to enhance audit efficiency.

Audit efficiency: Growth in large partnerships

According to the report, businesses have shown increasing preference to organizing as partnerships and other pass-through-entities instead as C Corporations in recent years. As can be noted from the following graph, during tax years 2002 through 2011, the number of partnerships and S corporations of all sizes increased 47% and 32% respectively, while the number of C corporations declined 22%:

Preference for partnership structure IRS audit efficiency

 

The report highlights that although IRS hasn’t defined what constitutes a large partnership, the GAO has defined it as those having $100 million or more in assets and 100 or more direct and indirect partners. The report notes that the number of large partnerships has more than tripled between 2002 and 2011 to 10,009. The following chart sets forth an example of a complex partnership structure:

Complex partnership structure IRS audit efficiency

 

Moreover, many of the new large partnerships are concentrated in the finance sector. For instance, in tax year 2011, about 73% of large partnerships reported being in the finance and insurance sector, up from 64% in tax year 2002:

Concentration in finance sector IRS audit efficiency

 

Challenges before IRS to audit

Thanks to complex partnership structures and audit procedures, the GAO report highlights that the IRS audits less than 1% of large partnerships, well below the 27.1% undertaken in fiscal year 2012 for C corporations:

Audit rate for large partnerships IRS audit efficiency

 

The GAO report points out that most audits resulted in no change to the partnership’s return and the aggregate change was small. Citing the views of IRS auditors, the GAO report highlights that the audit results may be due to challenges such as finding the sources of income within multiple tiers while meeting the administrative tasks required by the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) within specified time frames. The following chart captures the audit process timeline under TEFRA:

Audit process timeline IRS audit efficiency

 

The following exhibit captures the audit process under TEFRA:

 

Audit process under TEFRA IRS audit efficiency

Citing interactions with IRS focus group participants, the GAO report notes the requirements of TEFRA procedures with increasingly complex partnership structures has reduced the amount of time to effectively audit the return within the statute of limitations.

The GAO report concludes that the relatively low rate at which IRS audits large partnerships and the minimal results achieved raise concerns about the agency’s ability to ensure the tax compliance of large partnerships. The report has recommended an eight-point action plan for the Commissioner of Internal Revenue that includes revising IRS activity codes to facilitate tracking large partnership audits and subsequently analyzing audit results.