Ledes from the Land of Enchantment

New audit structure too early for firm results

In 2015, Congress passed a law creating a new structure to handle partnership tax audits.

Audits now occur at the partnership level with IRS dealing with a “partnership representative” (PR).

We call the new structure “centralized audits.” It is a radical change from the old audit procedures. I believe most partners underestimate how significant the change is.

In a centralized audit, the partnership itself will be assessed taxes, penalties and interest. The PR may either cause the partnership to pay the assessment or take one of several alternative options. One is to “push out” the tax assessment to the partners.

The PR will have unconstrained powers to bind the partnership in dealings with the IRS. The partners may try to constrain the PR by agreement, but they remain bound by the PR’s actions with the IRS.

The change was so significant that the 2015 law was deferred until 2018. Partnerships could elect to “early” adopt the new rules as early as 2016.

Certain “small” partnerships may elect out of the centralized audit procedures. There will continue to be “regular” partnership audits for the elect-out group.

In March, the Treasury Inspector General for Tax Administration (TIGTA) released a report of the early centralized audits. It covered 480 audits for 2016 through 2019 years.

TIGTA found a curious result. Of the 480 centralized audits, 376, or 78%, were closed with no changes. This was significantly higher than the 50% no-change rate for “regular” partnership audits during the same period.

Several other things surprised TIGTA. IRS had not set any goals for centralized audits. The selection criteria was said to be no different than for regular audits.

TIGTA concluded that the high rate of no-change audits is a problem. I suspect that many of you think their point is that the IRS should be more aggressive in shaking money out of these taxpayers.

But TIGTA had more subtle points to make. First, a high percentage of no-change audits means that IRS resources are being wasted on audits that produce no new revenues. The study even showed more time spent on the no change audits than the cases that closed with agreed changes.

Second, IRS spent $54 million preparing for the new audit regime. Technological implementation alone was $40 million. There should be goals set for expected audit results.

To be fair, the TIGTA study looks only at early results from an entirely new audit structure. The degree of difficulty of these audit procedures is high. Tax professionals and IRS personnel need training.

Abraham Lincoln said, “Give me six hours to chop down a tree and I will spend the first four sharpening the axe.” Maybe IRS is still sharpening.

Early adopters of the new rules for 2016 and 2017 may also be different than partnerships in general. We may need longer-term data.

The ax also seems to be more easily directed at larger targets. IRS audits are handled by a “large” and a “small” group. The large group deals with taxpayers with assets of $10 million or more.

Of the 480 centralized audits in the study, 84 were handled by the large group and 396 by the small group. The no-change rate was 38% for the large partnerships and 87% for the small.

TIGTA also pointed out that new hire training in partnership tax returns could not, under IRS procedures, begin until 12 months after hire. Again, maybe the ax is still being sharpened.

Partnership tax filings present compliance problems. They are growing in number and in total amount of income. They present compliance problems.

Most taxpayers have their income reported to the IRS on W-2 and 1099 forms. Both are prepared by third parties with no incentive to play with the reported numbers.

Partnerships do not pay tax. They report shares of income to partners using a K-1 schedule. The partners report what the K-1 says.

Unlike the W-2 and the 1099 forms, the K-1 is prepared by a partnership that is often controlled by the very people who use the form in preparing their own returns.

TIGTA’s study is too small to draw clear conclusions. We really should hope it reflects four years of sharpening the axe.

Jim Hamill is the director of tax practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at [email protected].

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