IRS Launches Large Partnership Audits

For years, the IRS has committed to audit more partnerships. This is the year that it plans to deliver on its commitment. Partnerships and their advisors should get ready. The first audit notices for the new IRS Large Partnership Compliance Program are being issued this fall.

Background

The Bipartisan Budget Act of 2015 created, among other things, a new centralized partnership audit regime, generally effective for taxable years beginning in 2018. The BBA provides for the determination of partnership adjustments at the partnership level, and it also empowers the IRS to assess and collect tax attributable to those adjustments from the partnership itself. The partnership may “push out” the adjustments to its partners, but it is the partnership that must pass through the adjustments and the partners who must determine the resulting tax liability, rather than the IRS.

With these new rules, Congress gave the IRS several structural advantages. For instance, under the BBA, the default is that the audited partnership is liable for any imputed underpayment resulting from adjustments to partnership-related items. In calculating the imputed underpayment, adjustments that are favorable often cannot be netted against unfavorable adjustments, and the highest tax rate for the reviewed year (i.e., the year under audit) is applied to the combined adjustments. This results in an imputed underpayment that likely exceeds the amount of tax that would be due from the partners if the partnership and its partners had originally reported the items as adjusted by the audit. Although partnerships may be able to reduce the amount of the imputed underpayment through special modification procedures, those procedures are limited, cumbersome, subject to the IRS’s discretion, and may only partially correct the effect of the overinclusive imputed underpayment calculation.

As mentioned above, the BBA provides an alternative mechanism for paying the imputed underpayment by allowing partnerships to push out adjustments to the partners from the reviewed year, who then calculate and include an “additional reporting year tax” on their return for the year that includes the date the partnership furnishes the push-out statement—the “reporting year.” However, this option is subject to an interest rate that is 2% higher than the rate generally applicable under the default payment at the partnership level. Also, in the event that the adjustment pushed out to a partner is favorable and would result in a decrease in tax, the IRS currently takes the position that a partner is entitled to a refund only to the extent that the partner has overpaid taxes for the reporting year. The practical effect of the IRS position is that favorable adjustments, in many cases, may not give rise to the full refund amount the partner would otherwise expect, and nothing in the guidance appears to provide the partner a carryover or carryback of the decrease in tax that does not result in a refund.

Further, the scope of items that can be audited at the partnership level is extremely broad. “Partnership-related items” include any items shown or required to be shown on a partnership return or required to be maintained in the partnership’s books and records that may affect any person’s Chapter 1 income tax liability. The “Partnership Representative” holds the sole power to act on behalf of the partnership in a partnership audit and is the only person that the IRS is required to communicate with—other partners do not have any rights under the statute or regulations to participate in the audit.

As part of the regulatory project implementing the BBA regime, Treasury and the IRS made a promise: "[T]he IRS intends to increase the number of partnership audits for both partnerships that are subject to the centralized partnership audit regime and partnerships that have elected out of the partnership audit regime.” REG-136118-15. Budget constraints and the 2017 tax reform implementation forced the IRS to defer this commitment, however, until now.

IRS Launches New Partnership Enforcement Efforts

The IRS is starting a concerted enforcement effort to address partnership issues. IRS and Treasury leaders are publicly committing to this effort, across the organization, in a well-coordinated way. More importantly, the IRS is implementing structural changes to its enforcement program. Most recently, legislative proposals have included provisions that would substantially increase funding to the IRS to support enforcement efforts.

As a major program priority, the IRS has developed a new audit selection program for large partnerships similar to its Large Corporate Compliance Program. The LCC Program subjects some of the largest and most complex corporations to in-depth and often continuous examinations. Over the summer of 2021, the IRS launched the Large Partnership Compliance (LPC) program, using data analytics to select 2019 tax year large partnership returns for audit. As a result, the IRS is now sending initial audit notices to the selected large partnerships. The agency is employing experienced revenue agents well-versed in Subchapter K to conduct these audits. Additionally, it has hired many tax professionals with private-sector expertise in pass-through tax issues to assist with the enforcement efforts. Between October 2020 and October 2021, the number of Large Business & International (LB&I) revenue agents increased by over 200.

LB&I is also devoting significant resources to its Global High-Wealth Program and has committed to identifying high-income non-filers. LB&I is intent on increasing its coverage of these taxpayers, with an emphasis on their connected business entities that often include partnerships. In its Fiscal Year 2022 Focus Guide, LB&I listed among its strategic goals an increased focus and coverage in the pass-through area, including through the LPC program and other campaigns and projects.

As noted above, the IRS plans to use data analytics in selecting large partnerships for audit under the forthcoming initiative. E-filed partnership returns feed directly into the agency’s data analytics programs. Proposed regulations released earlier this year would require any partnerships filing 10 or more information returns of any kind, including Forms 1099, Forms W-2, and the like, to e-file returns due to be filed in calendar years after 2022. In addition to leveraging the e-filing process, the IRS is using machine learning and artificial intelligence to support LB&I’s strategic goal of identifying more productive work for employees. LB&I recently issued a memorandum explaining its classification and audit procedures for the new LPC program. In short, agents will not have discretion to “survey” or “pass” on issues identified for an LPC examination. According to the memorandum, LB&I needs data to hone its selection criteria.

While implementing the initiatives described above, the IRS also has recently significantly altered and enhanced required reporting for partnerships. For example, for the 2019 taxable year, partnerships were required to report negative tax capital accounts, and beginning in the 2020 taxable year, partnerships were required to report partners’ tax capital accounts. New, enhanced reporting is now required with respect to, for example, Section 704(c) built-in gains and losses, as well as many new items relating to new provisions enacted in the Tax Cuts & Jobs Act, or TCJA. In addition, new questions have been added to the forms—such as for disguised sales and transfers of partnership interests that may have been subject to the new Section 864(c)—regarding transfers from foreign partners, among other questions. Further, for the 2022 filing season, the IRS is requiring detailed Schedules K-2 and K-3 standardizing the reporting of international items, which will significantly augment the amount of information reported to the IRS and to partners. These structural changes show that the recent partnership enforcement push is not just a fad.

What Is the IRS Focusing On?

What is the IRS looking for when selecting partnerships for audit? Here are just a few items, many of which are coordinated enforcement campaigns:

• High-income non-filers, many of whom receive partnership Schedules K-1 and other information returns.
• Deferred compensation attributable to services performed before Jan. 1, 2009 (IRC 457A).
• Financial service entities engaged in a U.S. trade or business (offshore lending).
• Whether management fees paid by private equity portfolio companies should be recast as constructive dividends (IRC 162).
• Transfer pricing adjustments on related-party loans and other controlled transactions (IRC 482).
• SECA Tax—whether distributions to limited partners and members of LLCs and LLPs should be subject to self-employment tax (IRC 1402), and
• Whether management and incentive fee waivers should be respected for tax purposes.

LB&I’s active compliance campaign inventory also includes a compliance campaign focused on the Tax Cuts & Jobs Act (TCJA). The TCJA includes several partnership provisions that are subject to review by the IRS on audit, including the qualified business income deduction (IRC 199A), limitations on excess business losses for taxpayers other than C corporations—since partially repealed by the CARES Act (IRC 461(l)), the taxation of carried interests for managers of private-equity and hedge funds (IRC 1061), and the treatment of disposition of partnership interests by foreign persons (IRC 864).

Conclusion

The structural changes to the audit rules, increased IRS enforcement resources, and a coordinated, data-driven approach to selecting returns for audit all further the IRS’s commitment to auditing more partnerships. Partnerships, partners, and their advisors should be prepared.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Greg Armstrong is a director in the Practice, Procedure and Administration group of the Washington National Tax (WNT) practice in KPMG LLP, Ossie Borosh is a principal in WNT’s Passthroughs group and Tom Greenaway is a principal in WNT’s Tax Controversy & Dispute Resolution group.

We’d love to hear your smart, original take: Write for Us