This post was originally published on Forbes April 30th, 2015
You would think that if a partnership was audited and there was an income adjustment in the millions, that would be really bad news for the partners, but a report just released by the Treasury Inspector General for Tax Administration (TIGTA) indicates that such an adjustment might have no effect at all thanks to an undisclosed “specific tolerance amount”.
The report recommends that the IRS come up with better measurements of the revenue generated by partnership audits. The IRS responded that resource limitation preclude implementation of some of TIGTA’s recommendations. Overall the report might be a bit demoralizing to practitioners who strive to get things right in a fairly complex area. On the other hand, those inclined to play the audit lottery (a violation of AICPA ethical standards by the way) would be cheering if they read this report. Of course, the latter crowd does not include a lot of readers of arcane tax material.
The Problem With Partnership Audits
The problem is that when a partnership is audited, it is not the partnership that is liable for the additional tax (or due an additional refund). It is the partner that is liable. So back in the day auditing a partnership meant auditing each of the partners, which could produce different results in the “let’s make a deal game”. In 1982 the Tax Equity and Fiscal Responsibility Act (TEFRA) created a unified procedure for some partnerships. The IRS deals with a “tax matters partner” (My alternative tax blog is called “
Your Tax Matters Partner” by the way. Pretty clever?). At the end of the audit, assuming it is not a “no change”, a Final Partnership Administrative Adjustment (FPAA) is issued.
A partnership is a TEFRA partnership if it has more than 10 partners or one or more of the partner is itself a flow-through entity. The Small Business/Self-Employed (SB/SE) Division’s Campus TEFRA Function (CTF), which operates out of the Ogden Campus in Ogden, Utah, and the Brookhaven Campus in Holtsville, New York, is responsible for identifying and linking TEFRA partnership returns to the taxable partners and assessing (or refunding) any associated taxes resulting from TEFRA audit adjustments.
How they get this job done at all, much less well, is a little mind boggling. Partnerships can have thousand of partners. On top of that if any of the partners are flow through entities (which is pretty common) the adjustments have to go to another level.
Nobody Knows What Partnership Audits Yield
Apparently some partnerships are getting audited. According to TIGTA there have been billions of dollars in partnership adjustments, but the IRS has no way of knowing how much revenue has been generated from those adjustments. Also there are problems with the systems to go from partnership adjustments to assessing tax on the partners. (That didn’t strike me as that big a number really)
TIGTA had five recommendations – develop a strategy to measure success and productivity of partnership audits, develop a system to determine amount off taxes assessed as the result of partnership audits, ensure that audit closing and assessment efforts are included in productivity measurements, update audit report writing software and coordinate with Treasury to assess the impact that proposed changes to the tax laws would have on the IRS’s partnership audit process.
The IRS agreed that all the recommendations are good ideas, but it is limited in its ability to implement them, because of budget issues.
Big Adjustments Can Produce No Tax
What is interesting to me as a practitioner is some of the data in the report. As of 2011 there were 3.3 million partnerships. Between fiscal years 2010 and 2013 IRS completed 31,044 partnership audits of which 11,123 were TEFRA audits. The average TEFRA audit takes the IRS 58 hours to complete compared to 34 hours for non- TEFRA audits. Nearly half of the audits are no change.
When I thought about it, this is not really that surprising. A significant part of my career has been devoted to partnerships and, knock on wood, I can’t recall any audits at all. Not only that in the waning days of my career I was assigned to what we called “private wealth services” and many of those clients would have extremely complicated K-1s from hedge funds that seemed to own an interest in everything everywhere. Not once did I see somebody’s return get adjusted by a FPAA.
That never seeing a return adjusted by a notice of Final Partner Administrative Assessment is actually explained in the footnotes of this report
The IRS uniformly applies an assessment tolerance to each partner. Therefore, if the IRS determines that a potential assessment will fall below tolerance, the assessment will not be made. The IRS does not publicly release the specific tolerance level.
Wouldn’t it be really cool to know that “specific tolerance level”? It is high enough that in some instance adjustments in the millions will produce no tax revenue.
On occasion, the IRS has been faced with the challenge of securing a settlement agreement at the partnership level because the millions of dollars in adjustments would have resulted in zero taxes after applying the assessment tolerance for taxable partners.
One workaround that the IRS has is to persuade the partnership to pay tax for its partners at the highest marginal rate. I could see the temptation to do that rather than have a couple of thousand people get aggravated by a notice of additional tax due with possible implications for future returns. A general partner who knew what the “specific tolerance level” is might be inclined to call the IRS bluff.
Why Do We Even Bother?
I do have to say that this report is just a bit demoralizing to someone who has spent a lot of time trying to get partnerships right. And there are people in the industry who go on crusades to convince clients that they need to spend a lot of money in order to do a better job. When I went from a large regional to a national firm, I was a little shocked that the standard partnership engagement letter indicated that helping with capital account maintenance was extra. There was this special team that would “deploy” across the country to do capital account studies, for some really stiff fees.
The bright young guy running that project became one of the few people that I thought it was worthwhile to ask partnership taxation questions. He was one of the big upsides to working for a national firm. (The tax season meals were a lot better too.) On the other hand, having it in the engagement letter that we would charge extra to do the return correctly was a little disturbing. Of course, there are players other than the IRS that might give a general partner a hard time about screwing up the returns, particularly the allocations, so perhaps those capital account teams were providing significant value.
Many states will have large partnerships routinely file returns where the partnership pays tax on behalf of some or all of the partners. Something like that at the federal level might make life simpler for everybody. Of course, we are unlikely to see any such reforms anytime soon.
Other Comments
Charlie Egerton of Dean, Mead, Egerton, Bloodworth, Capouana & Bozarth in Orlando served as chair of the ABA’s Tax Section and before that chair of the Committee on Partnerships and LLCs. He used to be and now is again about the only guy I think it is worth asking partnership tax questions.
This has become a real strain on the Service, given their short staffing from the constant budget cuts. I know that they are working on building a partnership specialty team, which would be very appropriate approach to more effectively audit complex partnership sturctures. To compound the problem, the TEFRA rules are badly in need of a legislative fix—they just don’t work well, especially in the complex world of multi-tiered partnerships. Having said all of this, I was not aware of any assessment tolerance rules of thumb, but I guess it is not surprising given their limited staffing and need to get the most bang for the buck on the partnership returns that they select for audit.
