Complex large partnerships force repeal of the Tax Equity and Fiscal Responsibility Act.
There has been a tremendous growth in the number of large partnerships in recent years. The Government Accountability Office reports that the number of large partnerships has tripled since 2002. A large partnership is a partnership with at least 100 partners and $100 million in assets. These partnerships report billions of dollars of revenue each year. Together they hold more than $7.5 trillion in assets.
Large partnerships include hedge funds, private equity funds, and publicly traded partnerships. These partnerships are so large that some have 100,000 or more partners arranged in multi-tiered partnership structures.
According to the GAO, there were more than 1,000 partnerships with greater than a million partners in 2012. In addition, some of these partnerships are publicly traded partnerships and the ownership interests in these partnerships changes every trading day.
Large partnerships are very complex structures. Due to their size and complexity, the audit procedure used by the IRS has not been effective. As a result, the IRS has audited only a very small percentage of these large partnerships. A Government Accountability Office study found that the IRS audited less than one percent of large partnerships in 2012.
The tax audit inefficiency has existed because of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). TEFRA was enacted at a time when partnerships were relatively small. The typical large partnership back in 1982 had fewer than 50 partners, not the 100,000 or 1,000,000 partners we see today. TEFRA has limited the ability of the IRS to perform effective audits.
Due to their size and complexity, the audit procedure that was used by the IRS has not been effective with large partnerships.
The newly enacted Bipartisan Budget Act of 2015, P.L. 114-74, signed November 2, 2015, has repealed the outdated provisions of the Tax Equity and Fiscal Responsibility Act. The Bipartisan Budget Act of 2015 will focus on streamlining the audit and adjustment procedures used for large partnerships.
Growth in Partnerships
One of the first decisions a business must make is its choice of entity. A business must choose whether to operate as a C Corporation, S Corporation, or Partnership. Many things must be considered in making the right choice. Choice of entity has serious implications in the formation, operation, and termination of the entity. Both non-tax and tax implications must be considered.
Of the entity choices available, the most flexible and tax-advantaged is the Partnership. It is no surprise that the most significant growth in entity type in recent years has been in Partnerships.
Some of these partnerships ... have 100,000 or more partners arranged in multi-tiered partnership structures.
IRS data shows that in the period from 2001 to 2011, partnerships have grown from about 2 million entities to 3.3 million entities. The combined book value of partnership assets is more than $20 trillion. Approximately 2 million of these entities are limited liability companies, and the rest are either general partnerships or limited partnerships.
Most of the partnerships are small businesses, with few partners in a simple single-tiered structure. However, some of the biggest growth is in the large partnerships with several hundred partners, more than a $100 million in assets, and operating in tiered structures.
The number of large partnerships has more than tripled to 10,099 from tax year 2002 to 2011 according to the Government Accountability Office. A large partnership is defined as a partnership with at least 100 partners and $100 million in assets.
These partnerships have revenues totaling billions of dollars per year and hold more than $7.5 trillion in assets. They are mostly in the finance and insurance sector, or investment funds. Large partnerships include hedge funds, private equity funds, and publicly traded partnerships.
Approximately two-thirds of these large partnerships had more than 1,000 direct and indirect partners. Some of these partnerships are so large that some have 100,000 or more partners arranged in multi-tiered partnership structures. Some partnerships had six or more tiers. The GAO reports that there were more than 1,000 partnerships with greater than a million partners in 2012.
Unlike C Corporations that file tax returns and pay income taxes, partnerships are not taxpayers. Partnerships do not pay income taxes. Partnerships only file information returns. Partnerships are tax conduits; they are pass-through entities from which income, and losses, pass through to their partners. In large partnerships with many partners and multiple tiers, effective tax audits can be near impossible.
The GAO report found that the ability of the IRS to audit these tiered large partnerships was limited. The audit of such an entity was time-consuming and challenging. Due to the size and complexity of these partnerships, just the simple process of tracing income through the tiers to the ultimate partners has been a great challenge.
Tax Equity and Fiscal Responsibility Act of 1982
The Tax Equity and Fiscal Responsibility Act created the unified partnership audit and litigation procedures of the Internal Revenue Code. The intent was to establish procedures to streamline audits of partnerships by requiring that partnership issues be handled in a single, unified partnership-level proceeding, instead of multiple proceedings at the partner level.
Large partnerships include hedge funds, private equity funds, and publicly traded partnerships.
At the time TEFRA was enacted, partnerships were relatively small. The large partnerships back then had fewer than 50 partners, not the 100,000 or 1,000,000 partners we see today. TEFRA had many outdated provisions and administrative burdens that did not work for today's large partnerships. As a result, the IRS audited very few of these large partnerships, and when it did, most of the audits resulted in no change to the partnership's return.
The Bipartisan Budget Act of 2015 [focuses] on streamlining the audit and adjustment procedures used for large partnerships.
The Tax Equity and Fiscal Responsibility Act was a burdensome law. IRS auditors found it difficult to satisfy the administrative tasks required by TEFRA on a timely basis. Large partnerships make it difficult to find sources of income within the multiple tiers. Large partnerships also make it difficult to find the "tax matters partner."
The Tax Matters Partner is the main contact between the IRS, the partnership, and its partners. It can sometimes take months to identify the partner that represents the partnership in the audit. Oddly, TEFRA did not require large partnerships to identify the tax matters partner on their tax returns. The confusion regarding the tax matters partner reduced the time available to conduct the audit.
Partnerships do not pay income Taxes ... [They]only file information returns.
Also, under TEFRA, unless the partnership elected to be taxed at the entity level, the IRS had to pass audit adjustments through to the ultimate partners. The process of determining each partner's share of the adjustments was arduous and, in effect, limited the number of audits the IRS could conduct.
Time is of the essence in the performance of a tax audit. The IRS generally has a three-year statute of limitations to conduct a partnership audit. From the time the partnership return is filed and an audit begins, two years may pass. The IRS then has a year to assess the individual partners in the audited partnership to determine their share of the partnership audit adjustment.
Due to the many difficulties in the partnership audit process, very few large partnerships are ever audited. In fact, the IRS has audited less than one percent of large partnerships. Of the few large partnerships that are audited, only one-third have audit changes.
It can sometimes take months to identify the partner that represents the partnership in the audit.
At a recent Partnership Taxation Conference, an Internal Revenue Service associate chief counsel gave an illustration of the difficulty the IRS has had dealing with large partnerships even when a huge adjustment has been determined. The illustration was of a large partnership with 25,000 equal partners that the IRS determined had a $10 million increase in income.
The $10 million seems substantial, but it is only a $400 adjustment per partner. The IRS then has to go through the time-consuming task of locating 25,000 individual returns and calculating the tax adjustments on a per partner basis. The IRS cannot allocate appropriate resources to accomplish the adjustments described above.
The already limited resources of the IRS have been further limited by budget cuts to the agency. Budget cuts to the Internal Revenue Service have also compromised the large partnership audit process. As a cost-cutting measure, the fiscal year 2015 budget was reduced by 3% by Congress. Budget cuts mean fewer resources and personnel to effectively audit large partnerships.
Key members of Congress drafted new legislation to make auditing large partnerships easier and more efficient. There were differences between the House of Representatives and U.S. Senate proposals to the new bill. Despite the initial differences in the legislation, all parties agreed that change in the audit procedure for large partnerships was desperately needed. The final bill presented for enactment made the necessary recommendations to revise the existing partnership audit rules.
There are perhaps countless millions of dollars of additional tax revenue that could he found if effective audit measures had been taken.
The Internal Revenue Service has been unable to keep up with the growth in large multitiered partnerships. The size and complexity of these multi-tiered partnership structures make it very difficult for the IRS to effectively audit them.
The situation was further complicated by the outdated provisions in the Tax Equity and Fiscal Responsibility Act's (TEFRA). As a result, the IRS could not assure the proper tax law compliance of these large partnerships.
There are perhaps countless millions of dollars of additional tax revenue that could be found if effective audit measures had been taken. This situation certainly adds to the already huge tax gap that exists and makes for a less equitable tax system for all.
Elliott, Amy S. "Tax Analysts--IRS Failing to Audit High-Value Electing Large Partnerships." April 28, 2014. Accessed March 2.5, 2016. http://www.taxanalysts.com/www/features. nsf/Features/165C45057003EB3285257CC800 576E37.
Large Partnerships: With Growing Number of Partnerships, IRS Needs to Improve Audit Efficiency. http://www.gao.gov/products/GAO-14-732 GAO-14-732: Published: Sep 18, 2014. Publicly Released: Sep 18, 2014.
Large Partnerships: Characteristics of Population and IRS Audits http://www.gao.gov/products/GAO-14-379R GAO-14-379R: Published: Mar 19, 2014. Publicly Released: Apr 17, 2014.
Large Partnerships: Growing Population and Complexity Hinder Effective IRS Audits http://www.gao.gov/products/GAO-14-746T GAO-14-746T: Published: Jul 22, 2014. Publicly Released: Jul 22, 2014.
The Tax Equity and Fiscal Responsibility Act of 1982 (Public Law 97-248)
The Bipartisan Budget Act of 2015 Public Law No: 114-114th-74
Biagio Pilato, The Peter J. Tobin School of Business, St. John's University, New York
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|Publication:||Review of Business|
|Date:||Mar 22, 2016|
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