In September, the US Government Accountability Office (GAO) released a special report calling for major changes in the way the Internal Revenue Service (IRS) audits large partnerships, including private equity and hedge funds. The report expanded upon a preliminary July review, which claimed that large partnership structures – defined as having 100 or more direct and indirect partners and $100 million or more in assets – have grown too complex and too big to effectively audit.
Almost two-thirds of large partnerships, which in 2012 held $7.5 trillion in assets, have more than 1,000 direct and indirect partners and six or more tiers, “with many being investment funds,” according to the GAO. When dealing with such complex structures, IRS staffers have said they often do not even know where to start the audit process.
So, despite their significant share of the market, a mere 0.8 percent of large partnerships underwent an audit in fiscal year 2012, compared to 27.1 percent of large corporations. And, of the audits that were conducted in 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 just $1.9 million, the GAO said.
The latest study gave multiple recommendations to combat these shortfalls. The GAO recommends legislative action to alter the Tax Equity and Fiscal Responsibility Act (TEFRA) audit procedures and require partnerships to identify a point person responsible for audits – a tax matters partner (TMP) – and to have the partnership, rather than individual partners, pay taxes on audit adjustments.
At the departmental level, the GAO wants the IRS to put systems in place to track and analyze the results of large partnerships audits (which they cannot do with their current system) in order to identify suspicious activity and target only noncompliant firms in the future.
The report has raised speculation as to whether private equity firms will be subject to more audits. We spoke with Jim White, Director of Tax Issues at the GAO and author of the report, to discuss the possible implications going forward.
pfm: If Congress and the IRS were to take action in response to these recommendations, what would that potentially mean for the private funds industry?
White: The IRS knows so little about large partnerships and the results of its audits that it’s difficult to know what this will mean. Right now, the IRS is not doing many audits of large partnerships and, of the audits that are done, they’re getting very poor results. Those audits are essentially a waste of time, and that includes a waste of time on the part of the partnerships being audited.
Our recommendations are aimed at improving the efficiency of the audit process and that boils down to not doing audits on partnerships that are compliant. What we want to do is target audits on suspicious-looking partnerships where there is reason to believe there might be noncompliance.
How can the process be changed to target those suspicious-looking partnerships?
This needs to be a step-by-step process. We have two matters we asked Congress to consider and seven actions for the IRS to consider. If these recommendations are put in place, it will be possible to learn something from these initial steps and think about further actions.
What we recommended for Congress is a couple of changes we think would make sense right now. One is, if there’s any tax owed as a result of the audit, to make that tax payable by the partnership at the partnership level rather than having to pass it through to all the partners. When there’s thousands or tens of thousands or hundreds of thousands of partners, passing those audit changes through to them is a huge problem. Additional tax changes as a result of an audit at a C-corporation don’t get passed through to each individual shareholder, the corporation pays at the corporate level, and obviously that effects the profits of the corporation and what the shareholders share, and it would work the same way with a partnership.
Another action that would require legislative change is requiring partnerships to designate a qualified TMP (such as their CFO) so that IRS, when it starts an audit, knows which person it needs to be dealing with at the partnership.
In some cases, it can take the IRS months to figure out who that TMP is and there’s a limited window by statute for the IRS to do the audit. By the time returns are processed and selected for audit, there’s really about 18 months of active audit time. If several of those 18 months are spent trying to find a TMP, then there’s a significant reduction in the amount of time available for the audit.
We talked to a number of the frontline auditors that work on large partnership audits and they said that, in some cases, partnerships are trying to hide the TMP from IRS in order to drag out the process, and that is why it can take so long.
What would a timeline look like for implementing these changes?
The recommendations we made to IRS are things that can’t be done instantly. They would have to put some time and money into their information systems to better track partner audit results and do some analysis of those results, but they can be done in a reasonably short period of time.
These steps will require some resources to do and that’s an issue for the IRS, because their budget has been cut pretty substantially, but the way they’re using their existing audit resources right now is not accomplishing anything. They’re wasting resources right now as well as a wasting the partnership’s resources, so the idea here is to step back, get better at doing this and hopefully get more efficient at it. We will be regularly following up with IRS on their progress.
It’s harder to predict how long it will take for the matters we asked Congress to consider because they’re legislative actions.
What would you say to the private equity CFO following the progress of these recommendations?
This is a big deal. This matters because you’ve got a big shift going on in the economy in the way businesses are being organized and very rapid growth at the large partnership level. If the IRS does this kind of tracking, they can analyze the results and learn more about the characteristics that identify suspicious activity.
At the end of the day, they will be more able to target the audits on noncompliant partnerships and avoid doing audits resulting in no changes. There’s a group of partnerships that would potentially benefit from this, because they’d be less likely to be targeted for an audit.
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