The Impending Large Partnership Audits

In August, the Federal Bar Association Section on Taxation held an informative roundtable on the IRS’s new large partnership compliance or LPC program. One of the speakers, Maria Dolan with the IRS’s Large Business & International Division (LB&I), Pass-Through Entity (PTE) office, explained that the IRS designed the LPC program to increase audit coverage of this important taxpayer pool. She reported that some of the LPC audits will begin in October.[1] Dolan also observed that partnership audit changes effected through The Bipartisan Budget Act of 2015 (commonly known as the BBA) enable the IRS to conduct an audit that is more administratively efficient than those formerly faced by the members of this historically under-audited taxpayer pool.[2]

Taking cues from the White House’s suggested priorities for enhanced tax enforcement, i.e., audit the largest companies and the wealthiest individuals,[3] one might expect the IRS to begin by auditing the largest partnerships in the country. But the IRS has made no announcement to that effect. Ms. Dolan explained that her office will coordinate with the IRS’s risk analysis unit to identify potential audit targets that both meet a certain revenue and asset value threshold and satisfy certain objective criteria to a sufficient degree that demonstrates an audit is warranted as discussed in more detail below.

Audit Selection Process

The LPC program is similar to the existing large corporate compliance or LCC program and the LPC audit selection method is expected to follow the LCC program’s method.[4] The corporate program uses a two-step process to decide which taxpayers to audit. First, the IRS subjects all corporate returns to an automated review that utilizes “pointing” criteria. These criteria include such items as gross assets and gross receipts. Where a corporate taxpayer’s return satisfies enough of these criteria, it will join the audit pool. The IRS then uses data analytics to identify the corporate returns in the audit pool that pose the highest compliance risk.

It would be reasonable to expect that the LPC program will utilize a similar pointing system to populate the general audit pool of large partnerships. Thereafter, the PTE office would engage the LB&I Data Solutions Office to apply algorithms to help tease out those partnerships presenting the highest compliance risk. The IRS data analytics team derives its algorithms by first analyzing data gathered through a variety of sources, including income and information returns, tax information exchange agreements, other U.S. agency data, third-party commercial data and even data leaked from non-U.S. sources. The analytics team then connects the data to patterns and markers of tax avoidance and creates algorithms to detect the patterns or markers in the returns within the audit pool. Experienced examination teams will likely assist throughout the process. Once the PTE office selects a return, it will refer that return to an examination team for audit.

It is not anticipated that the IRS will select partnerships for audit based on predetermined audit issues. Unlike LB&I’s campaign approach to audits (which focuses on highest risk of noncompliance with respect to certain identified issues), the LPC program in all likelihood will not limit the selection of partnerships for audit or the examination of selected partnerships to instances where predetermined compliance issues exist. However, as we discuss below, there likely will be some overlap between existing campaign issues and LPC audits.

Audit Issues

As just mentioned, LPC audits will not be single issue audits. Instead, the entire return will be subject to audit and any issue, including subchapter K issues, can be on the table for examination. The pre-selection risk analysis will provide the IRS audit exam team with initial areas for inquiry, but the exam team is not constrained in any way and can review any item on the return. Further, there are several existing LB&I audit campaigns that would easily overlap with partnerships, e.g., the sale of partnership interests campaign, and examinations carried out through the revamped Global High Wealth program (which we have previously discussed[5]).[6] Additional issues that may arise in the Global High Wealth context include:

• In the case of foreign partners or transactions with foreign persons – withholding and reporting obligations, e.g., FDAP, FIRPTA, FATCA and ECI withholding; and
• In the case of related persons, which is fairly commonly in the Global High Wealth context – treatment of payments to partners and treatment of partners as employees.

Audits initiated pursuant to campaigns could also engage the LPC program if the partnership entities involved in those audits qualify as large partnerships and exhibit the requisite noncompliance risk. In that event, it is not clear whether the LPC audit team would take control of the management of the audit.

A Brief Overview of the Partnership Audit Process

After determining which partnerships will be selected for audit, the IRS will deliver audit selection notices (Letter 2205-D) to those partnerships. If there are no timely filed administrative adjustment requests, the IRS will initiate the audit through a typical notice (Letters 5893 and 5893-A). The audit then will proceed in typical audit fashion and, if the IRS believes adjustments are required, it will provide the partnership representative (and any person authorized under a power of attorney on Form 2848) with a summary of its report. If parties do not resolve the adjustment, the IRS examination team will issue a 30-day letter that enables the partnership to seek IRS Office of Appeals review.

Later Articles

In the subsequent months, we will publish additional articles discussing further details and developments as the LPC program proceeds, including a more in-depth focus on the audit process itself, and providing some practical advice regarding good audit practices. In that regard we note that under the BBA, the partnership representative has a high degree of discretion and authority over the conduct of the audit. In view of that authority, coupled with the elimination of the Tax Equity and Fiscal Responsibility Act (TEFRA) partner notice requirements, counsel for taxpayers under audit in the LPC program should ensure the partnership representative is complying with relevant notification obligations in the partnership agreement, particularly regarding actions that the partnership representative can take during the audit that could materially affect the course of the audit.

[1] Dolan reaffirmed the timing of the audits recently and stated that the LPC will address 2019 returns.  See Tax Notes Today, September 27, 2021, IRS Sees Growing Interest in Partnership Audit Options.

[2] The GAO published a report in 2014 titled LARGE PARTNERSHIPS With Growing Number of Partnerships, IRS Needs to Improve Audit Efficiency.  In that report the GAO noted the paucity of IRS audits of large partnerships defined as those with $100 million or more in assets and 100 or more direct and indirect partners.  At the time of the GAO report, section 775 of the Code defined “electing large partnerships” as a partnership with 100 or more partners.  The BBA repealed this section.     

[3] FACT SHEET:  The American Jobs Plan (noting recent study that found 91 Fortune 500 companies paid zero income tax in 2018) accessible at https://www.whitehouse.gov/briefing-room/statements-releases/2021/03/31/fact-sheet-the-american-jobs-plan/.

[4] Tax Notes Today, October 6, 2020, IRS Aiming for 2021 for Large Partnership Compliance Program (remarks of Nikole Flax, deputy commissioner, IRS Large Business and International Division).

[5] https://media2.mofo.com/v3/assets/blt5775cc69c999c255/blta6441a6b0b490721/6273213fa1a1dd2aa9f6cdc4/200925-managing-new-irs-global-audits.pdf. 

[6] For a complete list of active LB&I campaign issues see https://www.irs.gov/businesses/corporations/lbi-active-campaigns.  Aside from those issues which are specific to non-partnership persons, any of these issues could be identified within the context of an LPC audit.