IRS Stepping Up Scrutiny of Large Partnerships

The Internal Revenue Service (IRS) has announced that it plans to use an influx of new funding to step up scrutiny of large partnerships…

The Internal Revenue Service (IRS) has announced that it plans to use an influx of new funding to step up scrutiny of large partnerships. In support of its new initiative, the IRS cited the growing size and complexity of partnerships, along with relatively low audit rates in recent years.

Rise of the Partnership

Partnerships are increasingly popular because they allow businesses to pass income and losses to their partners rather than being taxed as corporations. According to the Government Accountability Office (GAO), the number of large partnerships—with over $100 million in assets and 100 or more partners—increased almost 600 percent between 2002 and 2019. While pass-through entities are simple in theory, many large partnerships involve complex tax arrangements.

IRA Funding to Support Partnership Audits

The Inflation Reduction Act of 2022 (IRA) provided IRS with $45.6 billion for enforcement activities through the end of fiscal year 2031. In September, the IRS announced several new compliance efforts utilizing IRA funding, which included increased focus on partnerships. The agency separately announced the creation of a new pass-through working group in the IRS Large Business and International (LB&I) division, which will examine partnerships, limited liability companies, and S corporations. 

Large Partnership Audits

The IRS indicated that its large partnership initiative would begin with the audits of returns filed by 75 of the largest partnerships operating in the United States. The audit targets generally have more than $10 billion of assets and cover a wide range of businesses, including hedge funds, real estate investment partnerships, publicly traded partnerships, large law firms and other industries. The IRS also stated that it expects the audits to address a broad range of subjects, including complex partnership issues, tax accounting, and international tax. 

Compliance Letters

The IRS also announced that it would begin mailing compliance letters regarding balance sheet discrepancies to around 500 partnerships in early October. Depending on the response, the IRS will add these to the audit stream for additional work.

According to the IRS, it has identified “ongoing discrepancies” on balance sheets involving partnerships with over $10 million in assets, which it deems as an indicator of potential non-compliance. “Taxpayers filing partnership returns are showing discrepancies in the millions of dollars between end-of-year balances compared to the beginning balances the following year. The number of such discrepancies has been increasing over the years,” the IRS wrote in a news release. “Many of these taxpayers are not attaching required statements explaining the difference. This effort will focus on high-risk large partnerships to quickly address the balance sheet discrepancy. Prior to the IRA, the IRS did not have the resources needed to follow up and engage with all the large partnerships with such discrepancies. However, the IRS will soon have the resources and plan in place to ramp up this effort.”

Increased Reliance on AI

Going forward, the IRS plans to use artificial intelligence (AI) to identify potential compliance issues and audit targets. “With the help of AI, the selection of these returns is the result of groundbreaking collaboration among experts in data science and tax enforcement, who have been working side-by-side to apply cutting-edge machine learning technology to identify potential compliance risk in the areas of partnership tax, general income tax and accounting, and international tax in a taxpayer segment that historically has been subject to limited examination coverage,” the IRS stated. The agency also plans to hire additional staff to enhance its AI capabilities.

Additional IRS Priorities

The IRS has identified several additional enforcement priorities for FY 2024. They include:  taxpayers with total positive income above $1 million that have more than $250,000 in recognized tax debt; digital assets (the IRS projects more digital asset cases will be developed for further compliance work early in Fiscal Year 2024); and Report of Foreign Bank and Financial Accounts (FBAR) non-filers. The IRS also plans to continue its work to notify consumers about emerging scams and identity theft risks. 

How to Prepare for IRS Scrutiny

Large partnerships have largely been able to operate under the radar for the past several years. According to the IRS, the lack of audits has allowed past-through abuse to flourish, particularly among wealthy taxpayers. Given that even well-meaning taxpayers are often swept up in IRS initiatives, we encourage businesses to work proactively to identify potential compliance issues and reduce audit risks. 

If you have any questions or if you would like to discuss the matter further, please contact me, Scott Novak, or the Scarinci Hollenbeck attorney with whom you work, at 201-896-4100.