IRS: GPs too big to audit

A non-partisan government report confirmed IRS complaints that large complex partnerships are too difficult to unravel during audits.

More GPs face the ordeal of an audit following an independent government review of large partnerships commonly used in the private funds space.

Investigators from the Government Accountability Office (GAO) backed claims from the US Internal Revenue Service that partnership structures have grown too complex and big to effectively audit.

The number of large partnerships more than tripled from tax years 2002 to 2011, reaching a total of 10,000, the report said.  Private equity and hedge fund managers were mentioned specifically as popular users of large partnership entities.

A mere 0.8 percent of large partnerships – defined as having 100 or more direct and indirect partners and $100 million or more in assets – underwent an audit in fiscal year 2012 compared to 27.1 percent of large corporations, the GAO said in a report released late last month.

During the investigation, IRS officials reported having difficulty tracing income from its source through the many tiers at a top partnership entity. Under these tiered arrangements, the amount of partners can run into hundreds of thousands, the report said. The IRS also said current tax law provides them limited legal authority to effectively conduct audits in a timely manner.

Of the audits that were done in fiscal year 2012, about two-thirds resulted  in no change to the partnership’s reported net income. The remaining one-third resulted in an average audit adjustment to net income of $1.9 million, the GAO said.

The report didn’t make any recommendations for legislative reform but a more detailed follow-up report expected later this year may propose specific actions, such as requiring partnerships to pay taxes on net audit adjustments rather than passing them through to the taxable partners.

Aside from cost and time considerations, the prospect of more audits isn’t necessarily causing concern in the industry.

“The typical private equity fund wouldn’t be a very interesting audit target,” said Peter Furci, a tax partner at law firm Debevoise & Plimpton. “The treatment of carried interest is clear under current law. Although there has been public discussion of management fee waiver profits interests by the IRS, we wouldn’t expect much audit activity on that until the IRS decides the approach they want to take in their regulation project. The rest of what most private equity funds do is pretty much right in the middle of the fairway.”