C Corporation: a corporation that is generally  taxed at the entity level under subchapter C of  the Internal Revenue Code (IRC). Partnerships report the share of  income or losses accruing to each partner on a Schedule K-1 with copies  going to the partners and to IRS. Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA)

In response to concerns about IRS’s ability to audit partnership returns,  Congress enacted specific rules regarding partnerships audits in  TEFRA. Most Large Partnerships Have Complex Structures with Thousands of Partners and Multiple Tiers

Almost two-thirds of large partnerships had 1,000 or more direct and  indirect partners in tax year 2011, but hundreds of large partnerships had  more than 100,000 partners. Several Challenges Related to Complexity May Limit IRS’s Ability to Audit Large Partnerships and to Recommend Changes

IRS officials said that they do not have sufficient data on the results from  field audits of large partnerships to know what is driving the high no   Our focus groups with IRS field  change rate and minimal tax changes.auditors and interviews with IRS officials, however, provided insights on  the challenges to finding noncompliance in field audits. TEFRA Reduces Time IRS Can Actually Spend on Audits  IRS focus group participants stated that the interaction of TEFRA  procedures with increasingly complex partnership structures has reduced  the amount of time to effectively audit the return within the statute of  limitations. Without a TMP, IRS is not able to  conduct the audit. For example, TEFRA does not require partnerships to designate a  TMP on their returns. If IRS does so within 45 days, IRS can close  the audit as no change without having to notify the partners. In  addition, time spent identifying the TMP reduces the time available to  make this determination. As a consequence, the process for passing audit adjustments through to  partners is costly and very time consuming. Large Partnerships May Pay Tax on Audit Adjustments Rather Than  Pass Them Through to the Partners but Such Payments are Not  Widely Used  Current law allows large partnerships to pay a tax owed as determined by  audit adjustments at the entity level rather than passing the adjustments  through to partners, which would avoid all the costs of campus audits. However, few large partnerships elect to  become an ELP. IRS has not developed the two field audit-related projects consistent with  project planning principles, as shown in table 9. Without  following the principles in table 9, IRS may not be able to assess whether  the projects succeeded in making large partnership audits more efficient  and effective. While IRS has initiated three projects to improve its audit procedures, it  has not followed project planning principles, including taking the steps  needed to effectively track the results for the two projects that have been  implemented. In its written comments, IRS agreed with our recommendations but said  two of our recommendations, related to revising IRS’s activity codes to  enable tracking large partnership audits and then analyzing audit results,  are dependent upon future funding. The names of  GAO staff who made key contributions to this report are listed in appendix  V.

Appendix I: Objectives, Scope, and Methodology

The objectives of this report are to (1) determine what IRS knows about  the number and characteristics of large partnerships; (2) determine what  IRS knows about the costs and results of audits of large partnership  returns and assess IRS’s ability to effectively conduct such audits; and (3)  identify and assess IRS’s efforts to address the challenges of auditing  large partnership returns. To determine the number and characteristics of large partnerships, we  obtained data on tax returns filed by large partnerships from the  Enhanced Large Partnership Indicator (ELPI) file on partnerships for tax  years 2002 to 2011, and on the number of partnerships with 100 or more  direct and indirect partners and $100 million or more in assets. To determine the number of IRS audits of large partnership returns and  the characteristics of those audits, we obtained data from the Audit  Information Management System (AIMS) and reported those partnership  returns subject to IRS audit that were closed during fiscal years 2007 to  2013.returns, we only reported those audits that were traditional IRS field  audits (in which IRS audited the books and records of a large partnership  return), and not campus audits (in which IRS usually passed audit  adjustments through to the related partners’ returns), as they are mainly  an administrative function and do not include an examination of the books  and records of the taxpayer return in question.
Why GAO Did This Study

More businesses are organizing as partnerships while fewer are C corporations. Unlike C corporations, partnerships do not pay income taxes but pass on income and losses to their partners. Large partnerships (those GAO defined as having $100 million or more in assets and 100 or more direct and indirect partners) are growing in number and have complex structures. Some partnerships create tiers of partnerships with hundreds of thousands of partners. Tiered large partnerships are challenging for IRS to audit because tracing income through the tiers to the ultimate partners is complex.
GAO was asked to assess IRS's ability to audit large partnerships. GAO's objectives include: 1) determine what IRS knows about the number and characteristics of large partnerships, 2) assess IRS's ability to audit them, and 3) assess IRS's efforts to address the audit challenges. GAO analyzed IRS data from 2002 to 2011 and IRS audit documentation, interviewed IRS officials, met with IRS auditors in six focus groups, and interviewed private sector tax lawyers knowledgeable about partnerships.

What GAO Found

The number of large partnerships has more than tripled to 10,099 from tax year 2002 to 2011. Almost two-thirds of large partnerships had more than 1,000 direct and indirect partners, had six or more tiers and/or self reported being in the finance and insurance sector, with many being investment funds.
The Internal Revenue Service (IRS) audits few large partnerships. Most audits resulted in no change to the partnership's return and the aggregate change was small. Although internal control standards call for information about effective resource use, IRS has not defined what constitutes a large partnership and does not have codes to track these audits. According to IRS auditors, 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. For example, IRS auditors said that it can sometimes take months to identify the partner that represents the partnership in the audit, reducing time available to conduct the audit. TEFRA does not require large partnerships to identify this partner on tax returns. Also under TEFRA, unless the partnership elects to be taxed at the entity level (which few do), IRS must pass audit adjustments through to the ultimate partners. IRS officials stated that the process of determining each partner's share of the adjustment is paper and labor intensive. When hundreds of partners' returns have to be adjusted, the costs involved limit the number of audits IRS can conduct. Adjusting the partnership return instead of the partners' returns would reduce these costs but, without legislative action, IRS's ability to do so is limited.
Note: A 3-year statute of limitations governs the time IRS has to conduct partnership audits, which is about equally split between the time from when a return is received until the audit begins and the time to do the audit. IRS then has a year to assess the partners their portion of the audit adjustment.
IRS has initiated three projects—one of which is under development—to make large partnership audit procedures more efficient, such as identifying higher risk returns to audit. However, the two projects implemented were not developed in line with project planning principles. For example, they do not have clear and measurable goals or a method for determining results. As a consequence, IRS may not be able to tell whether the projects succeed in increasing audit efficiency.

What GAO Recommends

Congress should consider requiring large partnerships to identify a partner to represent them during audits and to pay taxes on audit adjustments at the partnership level. IRS should take multiple actions, including: define large partnerships, track audit results using revised audit codes, and implement project planning principles for the audit procedure projects. IRS agreed with all the recommendations, but noted that revision of the audit codes is dependent upon future funding.