IRS Must Improve Large Partnership Audits, GAO Says

The number of large partnerships has more than tripled to 10,099 from tax year 2002 to 2011. Almost two-thirds of large partnerships had more than 1,000 direct and indirect partners, had six or more tiers and/or self reported being in the finance and insurance sector, with many being investment funds.

The Internal Revenue Service (IRS) audits few large partnerships. Most audits resulted in no change to the partnership's return and the aggregate change was small. Although internal control standards call for information about effective resource use, IRS has not defined what constitutes a large partnership and does not have codes to track these audits. According to IRS auditors, the audit results may be due to challenges such as finding the sources of income within multiple tiers while meeting the administrative tasks required by the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) within specified time frames. For example, IRS auditors said that it can sometimes take months to identify the partner that represents the partnership in the audit, reducing time available to conduct the audit. TEFRA does not require large partnerships to identify this partner on tax returns. Also under TEFRA, unless the partnership elects to be taxed at the entity level (which few do), IRS must pass audit adjustments through to the ultimate partners. IRS officials stated that the process of determining each partner's share of the adjustment is paper and labor intensive. When hundreds of partners' returns have to be adjusted, the costs involved limit the number of audits IRS can conduct. Adjusting the partnership return instead of the partners' returns would reduce these costs but, without legislative action, IRS's ability to do so is limited.

 

Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA)

 

Audit Timeline

 

 

 

Note: A 3-year statute of limitations governs the time IRS has to conduct partnership audits, which is about equally split between the time from when a return is received until the audit begins and the time to do the audit. IRS then has a year to assess the partners their portion of the audit adjustment.

IRS has initiated three projects -- one of which is under development -- to make large partnership audit procedures more efficient, such as identifying higher risk returns to audit. However, the two projects implemented were not developed in line with project planning principles. For example, they do not have clear and measurable goals or a method for determining results. As a consequence, IRS may not be able to tell whether the projects succeed in increasing audit efficiency.

                               Contents

Large partnerships, which we define as those with 100 or more direct and indirect partners and $100 million or more in assets, have grown even faster.¹ From 2002 to 2011, the number of large partnerships more than tripled to more than 10,000 and large partnerships hold trillions of dollars of assets.

Large partnerships create a number of tax law enforcement challenges for the Internal Revenue Service (IRS) that we have described in recent reports.² The challenges are due to the complexity of large partnerships as well as the number of partners. Since partnerships can be partners in other partnerships, large partnerships frequently have tiers of partnerships, creating indirect partners. Such complex structures make it difficult for IRS to find the source of income and then trace it through the tiers to the ultimate taxable partners. There are legitimate reasons for businesses to set up complex structures of entities, such as isolating one part of a business from liability for the losses of another part.

Because of the growth of large partnerships and the challenges IRS faces in auditing large partnerships, you asked us to assess IRS's ability to ensure compliance with the tax laws. Specifically, this report (1) determines what IRS knows about the number and characteristics of large partnerships; (2) determines what IRS knows about the costs and results of audits of large partnership returns and assesses IRS's ability to effectively conduct such audits; and (3) identifies and assesses IRS's efforts to address the challenges of auditing large partnership returns.

To determine the number and characteristics of large partnerships, we obtained data from IRS on tax returns filed by large partnerships for tax years 2002 to 2011.³ Using these data, we analyzed and reported data on the number of partnerships by asset size, number of direct and indirect partners, number of tiers, and industry sector. To determine what IRS knows about the costs and results of audits of large partnership returns, we obtained audit data from IRS for fiscal years 2007 to 2013.⁴ We compared the costs and results of large partnership audits to audits of corporate returns of the same asset size.⁵

To assess the effectiveness of IRS audits of large partnership returns, we reviewed relevant statutes, IRS data on large partnerships, IRS policies and procedures on partnership audits, and our recent reports on partnerships.⁶ We compared information available to the intent of the partnership audit procedures outlined in statute and internal controls standards for the federal government.⁷ This information included our interviews with IRS officials and private sector lawyers knowledgeable about partnerships as well as six focus groups with IRS auditors who have worked on large partnership audits. The results of the focus group data are not generalizable to all IRS audits and do not necessarily represent the official viewpoint of IRS. Instead, the results were used to identify themes in conjunction with the other forms of data we analyzed.

To identify and assess IRS's efforts to address the challenges, we reviewed IRS documents and interviewed IRS officials about the efforts. We compared information available on IRS's efforts related to large partnerships to criteria on project planning previously identified in prior GAO reports.⁸ These criteria were identified by conducting a literature review of a number of guides on project management and business process reengineering.⁹

For the purposes of this review, we determined that the data used in our analysis were reliable and all dollar values have been adjusted for inflation to tax year or fiscal year 2014. Our data reliability assessment included reviewing relevant documentation, interviewing knowledgeable IRS officials, and electronic testing of the data to identify obvious errors or outliers. For additional details on our scope and methodology, see appendix I.

We conducted this performance audit from October 2013 to September 2014 in accordance with generally accepted government auditing standards. Those standards require that we plan and perform the audit to obtain sufficient, appropriate evidence to provide a reasonable basis for our findings and conclusions based on our audit objectives. We believe that the evidence obtained provides a reasonable basis for our findings and conclusions based on our audit objectives.

Background

Having no statutory, IRS, or industry-accepted definition of a large partnership, we have defined a large partnership in two ways: 1) as having 100 or more direct and indirect partners and $100 million or more in assets, and 2) as having 100 or more direct partners and $100 million or more in assets.¹⁰ Including just direct partners does not capture the entire size and complexity of large partnership structures. Accounting for indirect partners does, but it also raises the issue of counting income and assets more than once (described below). In this report, we generally use the definition that includes direct and indirect partners but sometimes use both definitions when the distinction might matter.

Key Terms and Examples of Partnership Structures

Partnerships can be structured as tiers of pass-through entities creating direct and indirect partners. Table 1 defines key terms for a partnership structure.

            Table 1: Key Partnership Structure Terminology

 

Figure 1: Example of Simple Tiered Partnership Structure

 

 

 

For a partnership structure with multiple partners linked in networks with other partnerships, the partners, assets, and income may be counted more than once as seen in figure 2.

 

Figure 2: Example of Partnership Structure with Tiers and

 

Direct and Indirect Partners

 

 

 

IRS Audit Process for Large Partnership Returns

Large partnership audits typically involve two separate steps. One step is the field audit, which is a detailed examination of the partnership's tax return (Form 1065) and supporting books and records to determine whether income and losses are properly reported. The field audit may recommend adjustments to the income and losses.

The other step is called a campus audit.¹¹ Campus audits link partnerships to the tax returns of their direct and indirect partners. Adjustments to income or losses from the field audit may be passed through to the taxable partners responsible for paying any additional tax, based on the partners' shares in the partnership. Although IRS counts campus audits as audits, they usually do not involve an examination of a taxpayer's books and records.

Large partnership field audits follow one of two IRS procedures, which are set by statute:

Tax Equity and Fiscal Responsibility Act of 1982

In response to concerns about IRS's ability to audit partnership returns, Congress enacted specific rules regarding partnerships audits in (TEFRA) TEFRA.¹² TEFRA audit procedures were intended to streamline IRS's partnership audit process while ensuring the rights of all partners.¹³ Before TEFRA, IRS audited partners separately, leading to inconsistent treatment and making it hard to detect tax shelters.¹⁴ According to the congressional Joint Committee on Taxation (JCT), the complexity and fragmentation of the audits -- especially for large partnerships with partners in many locations -- led to some audits of partners' returns ending at varying times and some partners paying additional taxes while others did not. See table 2 for key features of TEFRA.

   Table 2: Select Features of Tax Equity and Fiscal Responsibility

 

Figure 3: Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA)

 

Audit Process

 

 

 

Electing Large Partnership (ELP) Audit Procedures

According to the U.S. Department of Treasury (Treasury) and IRS, applying TEFRA to audits of large partnerships became an intensive and inefficient use of limited IRS resources as IRS spent more and more time on administrative tasks.¹⁵ As a result, Congress established the Electing Large Partnerships (ELP) procedures as part of the Taxpayer Relief Act of 1997.¹⁶ In general, the procedures apply to partnerships with 100 or more direct partners in a taxable year that elect this alternative reporting and audit framework.¹⁷ The ELP audit procedures differ from the TEFRA procedures in two key ways: partnerships (1) may pay tax on audit adjustments instead of the partners, and (2) must report fewer items to the partners.

IRS Resource Constraints

As we have previously reported, IRS's appropriations declined by $855 million, or 7 percent, and IRS staffing declined by more than 10,000 full-time equivalents, or 11 percent, between fiscal years 2010 and 2014.¹⁸ Most of this staffing decline occurred in IRS enforcement, which is responsible for ensuring that tax returns, including partnership returns, comply with the tax laws.

Large Partnerships Have Grown in Number, Size, and Complexity Since 2002

Businesses Have Shifted From Organizing as C Corporations to Partnerships and Other Pass-through Entities in Recent Years

During tax years 2002 through 2011, the number of partnerships and S corporations of all sizes increased 47 percent and 32 percent, respectively, while the number of C corporations decreased 22 percent.¹⁹ See figure 4.

 

Figure 4: Number of Returns by Form of Business,

 

Tax Years 2002 to 2011

 

 

 

The Number of Large Partnerships Has More Than Tripled

During tax years 2002 through 2011, the number of large partnerships with 100 or more direct and indirect partners as well as $100 million or more in assets more than tripled to 10,099 -- an increase of 257 percent. Over the same years, total assets of these large partnerships (without accounting for double counting) increased 289 percent to almost $7.5 trillion.²⁰ Figure 5 shows the increase in the number of large partnerships for various asset sizes.

 

Figure 5: Large Partnerships, Defined to Include Direct and

 

Indirect Partners, by Asset Size, Tax Years 2002 to 2011

 

 

 

Almost two-thirds of large partnerships had 1,000 or more direct and indirect partners in tax year 2011, but hundreds of large partnerships had more than 100,000 partners. Large partnerships with the most direct and indirect partners had the greatest increase from tax years 2002 to 2011. See figure 6.

 

Figure 6: Number of and Percentage Increase in Large Partnerships,

 

by Direct and Indirect Partners, Tax Years 2002 and 2011

 

 

 

Note: Although 51 large partnerships had 500,000 or more direct and indirect partners in tax year 2011, we did not show the percent increase to avoid disclosure of information about specific taxpayers as the 2002 value is less than 10. Assuming a value of 10 in tax year 2002, this group of large partnerships increased 410 percent by tax year 2011. The growth rate would be higher if the value in 2002 was less than 10.

The number of large partnerships varies considerably from year to year due in part to investment choices made by other large partnerships. One IRS official said that the partnerships with more than a million partners increased from 17 in tax year 2011 to 1,809 in tax year 2012. The official attributed most of the increase to a small number of investment funds that expanded their interests in other partnerships. If those investment funds choose to divest their interests in other partnerships, the number of large partnerships would decrease significantly.

Tiering contributes to complexity. In tax year 2011, more than two-thirds of large partnerships had at least 100 or more pass-through entities and 36 percent had at least 1,000 or more pass-through entities as direct and indirect partners. These pass-through entities may be direct partners or may exist at various tiers below the direct partners. There is some evidence that large partnership structures are becoming more complex. In tax year 2011, 78 percent of the large partnerships had six or more tiers compared to 66 percent in tax year 2002.²¹

Tiering complicates determining the relationships and allocations of income and losses within a large partnership structure. For example, in figure 7, the allocation from the audited partnership on the far left side of the figure passes through eight partnerships along the bolded path before it reaches one of its ultimate owners on the right. This path also may not be the only path from the audited partnership to the ultimate owner.

 

Figure 7: Example of Partnership Structure

 

 

 

Note: This figure, adapted from IRS documentation, illustrates a hypothetical, complex partnership structure, which shows the relationship between various types of entities. The allocation of income and losses from the audited partnership on the far left side crosses eight pass-through entities, all of which are partnerships, along the bolded line before it reaches one of its ultimate partnership owners on the right side. This figure was originally used in our report on business networks. See Tax Gap: IRS Can Improve Efforts to Address Tax Evasion by Networks of Businesses and Related Entities, GAO-10-968 (Washington, D.C.: Sept. 24, 2010).

While this example of a partnership structure is complex, it has only 50 partners and 10 tiers. Large partnership structures could be much more complex. In 2011, 17 large partnerships had more than a million partners. According to an IRS official, several large partnerships have more than 50 tiers.

Large Partnerships Are Concentrated in the Finance Sector

In tax year 2011, about 73 percent of large partnerships reported being in the finance and insurance sector, up from 64 percent in tax year 2002 (see table 3).²² About 87 percent of those in the finance and insurance sector in tax year 2011 engaged in financial investment activities, of which about 70 percent reported $1 billion or more in assets.

    Table 3: Number and Percentage of Large Partnerships by Industry

IRS Audits Few Large Partnerships Due to Challenges Presented by the Complexity of Both the Partnership Structures and Audit Procedures

IRS Audits Less Than 1 Percent of Large Partnerships

IRS audits few large, complex partnerships. According to IRS data, in fiscal year 2012, IRS closed 84 field audits -- or a 0.8 percent audit rate.²⁴ This audit rate is well below that of C corporations with $100 million or more in assets, which was 27.1 percent in fiscal year 2012. See table 4.

   Table 4: Audit Rate for Large Partnerships and Large Corporations,

It is possible that some large partnership audits in table 4 are audits of different partnerships within the same large partnership structure. For example, if IRS audits one large partnership and then discovers that it needs to audit another large partnership in the same complex structure, those would count as two separate audits. Available IRS data did not allow us to determine how often this occurred.

Audits of Large Partnerships Resulted in Minimal Changes to Partnership Returns

Table 5 shows that most large partnership field audits closed from fiscal years 2007 through 2013 did not find tax noncompliance. In 2013, for example, 64.2 percent of the large partnership audits resulted in no change to the reported income or losses. In comparison, IRS audits of C corporations with $100 million or more in assets had much lower no change rates, as also shown in table 5. In addition, IRS audits of all partnerships, not just large partnerships, also had a lower no change rate of 47 percent in fiscal year 2013.

 Table 5: No Change Rate for Large Partnerships and Large Corporations,

When field audits of large partnerships resulted in changes, the aggregate amount was minimal, as shown in table 6.²⁶ This could be because positive changes on some audits were cancelled out by negative changes on other audits. In 3 of the 7 years shown in table 6, the total adjustments from the field audits were negative; that is, they favored the large partnerships being audited. This did not occur for audits of large corporations.

 Table 6: Total and Average Recommended Audit Adjustments to Net Income

   Table 7: Audit Time Measures for Field Audits of Large Partnership

IRS Reporting of Partnership Audit Data Does Not Provide Clear Picture of Large Partnership Audits

IRS data that report audit results for partnerships do not break out large partnerships, which would help inform audit resource allocation decisions. Without such a break out, our analysis of audit data for large partnerships relied on combining various databases. According to standards for internal control in the federal government, managers need accurate and complete information to help ensure efficient and effective use of resources.²⁷ IRS officials acknowledged that they need a better understanding of large partnership audits to improve resource allocation.

The problem arises because IRS's audit data codes -- known as activity codes -- are not specific enough to identify large partnerships.²⁸ IRS uses its activity codes to set goals for the number of returns IRS plans to audit in a fiscal year and track audit results. Because they do not identify large partnership returns, the current activity codes do not allow IRS to do the kind of analysis needed to plan resource usage, including the level of audit and support staff needed, for large partnership audits.

IRS has developed new activity codes that would distinguish partnership returns based on asset size and the type of income reported; but they are not scheduled to begin reporting the new activity codes until fiscal year 2017 due to resource limitations. IRS has not decided which activity codes would be used to define large partnership returns. Further, the new activity codes do not account for the number of partners, which IRS has identified as a major driver of resource usage for large partnership audits -- particularly for the work done at the campus. If these IRS activity codes do not account for such a driver of resource usage, IRS will not be able to make effective resource allocation decisions.

Revising the activity codes requires defining a large partnership for audit purposes, which IRS has not done. The exact definition matters less than ensuring that one definition is consistently applied so that there is agreement on the scope of large partnership audit efforts and results can be assessed.

IRS also does not distinguish between field audits and campus audits in counting the number of large partnership audits. When calculating its audit rate for all partnerships, IRS accounts for both field audits and campus audits, which misrepresents the number of audits that actually verify information reported on tax returns. Unless IRS separately accounts for field and campus audits, it cannot accurately measure audit results.

Several Challenges Related to Complexity May Limit IRS's Ability to Audit Large Partnerships and to Recommend Changes

IRS officials said that they do not have sufficient data on the results from field audits of large partnerships to know what is driving the high no change rate and minimal tax changes.²⁹ Our focus groups with IRS field auditors and interviews with IRS officials, however, provided insights on the challenges to finding noncompliance in field audits.

Complex Large Partnership Structures Make Audits and Detecting Noncompliance Challenging

The complexities arising from large partnership structures challenge IRS's ability to identify tax noncompliance. For example, IRS officials reported having difficulty identifying the business purpose for the large partnerships or knowing which entity in a tiered structure is generating the income or losses. In these cases, IRS auditors said they do not know with which partner or tier of the partnership structure to start the audit. Without finding the source of income and losses, it is difficult for IRS to determine whether a tax shelter exists, an abusive tax transaction is being used, or if income and losses are being properly characterized. Focus group participants said that complex structures could mask tax noncompliance. For example, one participant said

IRS officials stated that determining compliance is especially challenging when auditing the returns of hedge funds that often have an interest in many other partnerships and in investments -- such as financial derivatives that are complex and constantly changing, and can involve noncompliance, as we have previously found.³⁰ Focus group participants noted that the complexity requires them to invest extensive time to research and understand the structure of large partnerships and technical tax issues. For example, one focus group participant noted the difficulty of auditing the returns of large, complex partnerships:

TEFRA Audit Procedures Add Complexity to Audits of Large Partnerships

As the number and complexity of large partnerships have increased, aspects of the TEFRA audit procedures have become an impediment, according to focus groups and interviews with IRS officials.

 

Figure 8: Tax Equity and Fiscal Responsibility Act

 

of 1982 (TEFRA) Audit Timeline

 

 

 

Notes: A 3-year statute of limitations governs the time to complete partnership audits.

^b In fiscal year 2013, IRS took an average of 1.5 years to conduct a large partnership audit.

^c IRS generally completes within 1-year the assessment of audit adjustments to partners of the large partnership.

IRS focus group participants said that identifying a qualified TMP is a primary challenge in large partnership audits. The burden of doing so falls largely on IRS, taking time and effort away from doing the actual audit work. For example, TEFRA does not require partnerships to designate a TMP on their returns. In addition, TEFRA allows the TMP to be an entity, not a person. In either case, IRS auditors spend time requesting that the partnership designate a TMP or tracking down an actual person to act as a representative for the TMP -- unless the partnership chose to list that person on the Form 1065. IRS focus group participants cited various reasons for not being able to immediately identify the TMP. Some said that large partnerships are purposely unclear about the TMP as an audit-delay strategy. As one participant said:

If a large partnership does not designate a TMP on the partnership return, IRS will provide the partnership the opportunity to do so. If the partnership does not, TEFRA requires that the partner with the largest profit interest automatically becomes the TMP. However, if IRS determines that it is impracticable to apply this rule, then IRS may designate the TMP.³³ IRS officials said that they are hesitant to do so before giving the partnership an opportunity to designate a TMP because the IRS designation may be opposed by the partners and IRS needs to collect information to find a partner that meets the criteria. As a consequence, exercising this authority can still mean that the start of audit is delayed. However, if IRS were to move directly to the largest profit interest rule or chose to designate the TMP using its existing authority instead of reaching out to the partnership, IRS could save valuable time during the average 18-month window it has to completes the audit. IRS does not track data on the time spent identifying the TMP. Focus group participants said that identifying and qualifying the designated TMP could take weeks or months. Losing a few months from the 18 months to audit a large partnership could be significant to IRS field auditors.

IRS officials said IRS has issued new job aids and training on identifying the TMP, clarified TMP requirements, and added a section about TEFRA in the December 2013 revision of IRS Publication 541, Partnerships. However, these steps do not solve the fundamental problem of limited audit time being lost while identifying a TMP. A legislative change to TEFRA requiring all large partnerships to designate a TMP on their tax returns and to provide updated TMP information to IRS once an audit starts would solve the problem. Without such a change, IRS's field audits of large partnerships are inefficient which hinders its ability to fulfill its mission of ensuring tax law compliance. The costs of such a legislative change should be low. There would be no increased costs to IRS -- the change would reduce IRS's costs. Partnerships already have partners responsible for filing tax returns so designating a TMP should not be onerous.

IRS focus group participants said that they often do not have sufficient information to determine whether to close an audit within 45 days. In addition, time spent identifying the TMP reduces the time available to make this determination. As a result, of the 61 field audits of large partnerships closed in fiscal year 2013 as no change, none were closed within the 45-day period.³⁶ IRS has the authority under TEFRA to amend its regulation to lengthen this period for withdrawing an audit notice beyond 45 days without having to notify all the partners of the withdrawal. Extending the notice withdrawal period would save IRS audit resources and allow the resources to be more effectively used in ensuring tax law compliance.

• The process of linking partnership returns (Forms 1065), Schedule K-1s, and partners' returns (Forms 1040) is largely manual and paper driven. According to IRS officials, the campus information systems do not have the capability to automate the process. Paper copies of all these returns must be retrieved and linked in a very labor intensive process.

• The portion of the partnership audit adjustment that gets passed through to each partner must be manually determined by using the ownership share reported on the relevant Schedule K-1.

• The Schedule K-1 information may not always be accurate, as we have previously found, requiring IRS to contact the partnership and review the partnership agreement to clarify ownership shares among the partners.³⁷

• A copy of the partnership agreement must usually be requested from the partnership being audited and for potentially each partnership within the partnership structure that is linked. Partnership agreements may include special allocation for some income items that supersede the ownership interest reported on the Schedule K-1.³⁸ Finding special allocations requires detailed reviews of the partnership agreements of the partnerships within the partnership structure. According to IRS officials, this step cannot be automated. IRS officials also said that partnerships could provide special allocation schedules to IRS, which would eliminate the need to review the entire agreement.

IRS is unable to track aggregate campus audit costs and campus adjustments associated with a field audit due to limitations of its information systems. IRS has requested funding in its fiscal year 2014 and 2015 budget proposals for an updated information system that would allow it to automate the linking process and collect more robust data but funding has not been approved.

The Chairman of the House of Representatives Committee on Ways and Means and the Administration have also put forth proposals to address some of the challenges of auditing large partnerships.⁴⁰ While the proposals differ somewhat and apply to partnerships with different numbers of partners, both would allow IRS to collect tax at the partnership level instead of having to pass it through to the taxable partners. For example, the Administration developed a legislative proposal to make the ELP audit procedures mandatory for partnerships with 1,000 or more direct and indirect partners, known as the Required Large Partnership proposal. IRS officials said that these legislative proposals, if passed, would significantly help address challenges involved with passing through audit adjustments.

These proposals would involve tradeoffs and decisions about how to treat partners. For example, because the partners may be taxed at different tax rates, the single tax rate applied to the net audit adjustment at the partnership level may be different than the rate partners would pay if the adjustment was passed through.

Focus group participants said that some IRS locations have only one TEFRA coordinator to answer questions about partnership audits. For example, IRS has one TEFRA coordinator to support all audits in New York State. IRS officials said that the number of TEFRA coordinators declined from 28 in fiscal year 2006 to 20 in May 2014 while workload increased. One IRS official said that TEFRA coordinators have to respond to requests for assistance and review and process TEFRA audits for partnerships of all sizes, not only large partnerships. IRS officials said that they plan to hire two coordinators in fiscal year 2014 and five in fiscal year 2015.⁴¹

IRS counsel officials told us that they believe that the number of delayed responses is fairly low, in contrast to what focus group participants said, and IRS counsel strives to process all requests for legal advice within 45 days of receipt. However, IRS counsel officials said that they do not track the number of requests for large partnership audits; if known, the response time would help IRS auditors to plan their audit work. Such a change would be in line with IRS's strategic plan, which has a strategic objective on utilizing data to make timely, informed decisions.⁴²

In addition to help from stakeholders, IRS focus groups participants told us that they have trouble accessing refresher courses on TEFRA and partnership tax issues. IRS officials told us that IRS field auditors may not understand that such training is available and can be taken with the permission of their supervisors. They also said that such training is not usually mandatory and some auditors may choose to not take it. Ensuring IRS auditors have access to training would be in line with IRS's current strategic plan, which highlights the importance of building a talented workforce. IRS officials stated that they are developing and have implemented new tools and training to assist auditors with TEFRA rules and procedures. However, IRS's Large Business and International division -- the division responsible for auditing large partnership returns -- experienced a 92 percent reduction in available training funds from 2009 to 2013.⁴³ IRS officials said that this reduction meant eliminating face-to-face training and relying on new virtual training courses on TEFRA and partnership audits in general.

IRS Has Initiated Efforts That May Address Some Large Partnership Audit Challenges but Their Potential to Have Significant Impact Is Unclear

IRS has limited ability to directly address some of the challenges it faces auditing large partnerships. For example, IRS cannot make tiered partnerships less complex nor change the TEFRA audit procedures that are set in statute. Nevertheless, IRS has initiated three projects to improve its large partnership audit procedures. IRS has also begun an effort to better manage enterprise risk.

Audit Procedures Improvement Projects Are Missing Some Planning and Evaluation Steps

Table 8 describes the three audit procedure projects and their potential for addressing certain challenges based on our interviews with IRS officials and reviews of available limited documents.

            Table 8: IRS Efforts and Their Potential to Address Some

IRS has not developed the two field audit-related projects consistent with project planning principles, as shown in table 9.⁴⁴ These two projects did not meet three of the five principles.

           Table 9: Assessment of IRS's Field Audit-Related Projects

IRS Has Not Determined How Large Partnerships Should Be Incorporated Into Its Enterprise-Wide Risk Management

IRS began an enterprise risk management (ERM) program agency wide in 2014. According to IRS documentation, IRS needed to evaluate how risks are identified, prioritized, evaluated, and mitigated across the agency. ERM objectives include deploying resources effectively, identifying and managing cross-enterprise risks, identifying the level of risk IRS is willing to absorb, aligning that risk level with strategies, and reducing operational surprises, among others.

Large partnership audits and the challenges associated with them raise a number of the issues listed as ERM objectives. Because of the lack of information IRS currently collects and tracks about large partnership audits, it does not have a very clear picture of how effectively its audit resources are being utilized. Nevertheless, as large partnerships grow in number, IRS will have to make decisions about whether to reallocate audit resources away from other compliance work to conduct more large partnership audits.

IRS has not yet determined how large partnerships will be incorporated into its ERM effort. Without such a determination and without documentation of the risks considered, IRS managers and external stakeholders, including Congress, may lack a record of how compliance risks associated with large partnerships were identified and prioritized. We have previously reported on the benefits of risk management and identified elements of a risk-management framework.⁴⁶ Risk management is a strategy for helping program managers and stakeholders make decisions about assessing risk, allocating resources, and taking actions under conditions of uncertainty. We recognize that IRS's information systems currently provide little data on large partnerships, as noted in other sections of this report. Even though IRS is not explicitly planning for how many large partnerships to audit each year, it is devoting resources to such audits. IRS is implicitly making decisions about how to allocate audit resources between large partnerships and other types of taxpayers. A determination about how large partnership compliance risks are to be identified and weighed against the compliance risks of other types of taxpayers would better inform those decisions.

Conclusions

Large partnerships are a significant part of the economy and are increasing in number, size, and complexity. However, the relatively low rate at which IRS audits large partnerships and the minimal results achieved raise concerns about IRS's ability to ensure the tax compliance of large partnerships. IRS has little data available to know why its audits are finding so little tax noncompliance. That is because IRS has not consistently defined "large partnership" -- accounting for both the number of partners and amount of assets -- and devised a related coding system to track any audit results. Without such data, IRS cannot conduct analysis to identify ways to better plan and use IRS resources in auditing large partnerships as well as analyze whether large partnerships present a high noncompliance risk.

Without the data, testimonial evidence from IRS auditors indicates that they feel challenged to audit complicated partnerships for compliance without sufficient time and support. Existing audit procedures set in law and in IRS regulations add to the time pressures and constrain IRS auditors. Because so little is currently known about large partnership noncompliance, it would be premature to try to design overall, long-term solutions. An incremental approach could be based on what is currently known, including legislative changes that Congress should consider as well as actions that IRS should take.

Legislative changes could help IRS auditors deal with the time constraints and reduce the resource demands of large partnership audits. Requiring large partnerships to designate a qualified TMP that the field auditors can contact is a relatively simple step that could reduce audit delays. Requiring large partnerships to pay any tax due at the entity level would also save resources but would not be a simple change. Such a change would have differing impacts on partners who may be in different tax brackets. The change would save the resources that are now devoted to the paper driven, labor intensive process of passing adjustments through to large numbers of partners. Paying taxes due on audit adjustments at the entity level has advantages over other options for audit efficiency gains such as automating the current paper driven process. Even if IRS was given resources to modernize its campus information systems, parts of the adjustment pass-through process would continue to require labor intensive reviews of partnership agreements.

IRS can take several actions that would begin to provide better information about large partnership compliance and audit results, or that could lower audit costs. Actions that would be a first step towards better information for analyzing large partnership compliance include developing a consistent definition of a large partnership along with activity codes that could be used to track audit results. To lower audit costs and avoid wasting audit staff time, IRS could change its practice governing when to use its authority to select a TMP, and the regulation which established the number of days an audit can be open without triggering more costly closing procedures. IRS could also better ensure that limited calendar time is not wasted in an audit. It could do so by tracking delays in providing expert support, clarify when auditors can expect such support, and then use this information about the support that can realistically be provided to better plan the number and scope of new audits, so that the time allowed under the statute of limitations is more effectively used.

While IRS has initiated three projects to improve its audit procedures, it has not followed project planning principles, including taking the steps needed to effectively track the results for the two projects that have been implemented. Without doing so, IRS will not know whether the projects succeeded in improving audit procedures.

As large partnerships continue to grow in number and complexity, IRS will have to make strategic decisions about whether to reallocate scarce audit resources from other categories of taxpayers -- perhaps from C corporations which are declining in number -- to conduct more large partnership audits. IRS's new Enterprise Risk Management program provides a venue for weighing the compliance risks associated with large partnerships against those of other types of taxpayers.

Matters for Congressional Consideration

Congress should consider altering the TEFRA audit procedures to:

• Require partnerships that have more than a certain number of direct and indirect partners to pay any tax owed as determined by audit adjustments at the partnership level.

• Require partnerships to designate a qualified TMP and, if that TMP is an entity, to also identify a representative who is an individual and for partnerships to keep the designation up to date.

We recommend that the Commissioner of Internal Revenue take the following eight actions:

• Track the results of large partnerships audits: (a) define a large partnership based on asset size and number of partners; (b) revise the activity codes to align with the large partnership definition; and (c) separately account for field audits and campus audits.

• Analyze the audit results by these activity codes and types of audits to identify opportunities to better plan and use IRS resources in auditing large partnerships.

• Use existing authority to promptly designate the TMP under the largest profits interest rule or some other criterion.

• Extend the 45-day rule to give field audit teams more flexibility on when to withdraw an audit notice.

• Help field auditors for large partnership audits receive the support they request from counsel staff, TEFRA coordinators, and IRS specialists: (a) track the number of requests and time taken to respond; (b) clarify when responses to their requests should be expected; and (c) use the tracked and clarified information when planning the number and scope of large partnership audits.

• Clarify how and when field auditors can access refresher training on TEFRA audit procedures and partnership tax law.

• Develop and implement large partnership efforts in line with the five leading principles for project planning and track the results to identify whether the efforts worked as intended.

• Make and document a determination about how large partnerships are to be incorporated into the Enterprise Risk Management process.

We provided a draft of this report for review and comment to the Commissioner of Internal Revenue. We received written comments dated September 8, 2014 from IRS's Deputy Commissioner for Services and Enforcement (for the full text of the comments, see appendix IV). We also received technical comments from IRS, which we incorporated into the final report where appropriate.

In its written comments, IRS agreed with our recommendations but said two of our recommendations, related to revising IRS's activity codes to enable tracking large partnership audits and then analyzing audit results, are dependent upon future funding. We acknowledge in the report the resource constraints IRS currently faces. However, continuing to audit large partnerships with limited ability to track and analyze audit results will not help IRS make sound resource allocation decisions or improve audit effectiveness.

We are sending copies of this report to the Secretary of the Treasury, the Commissioner of IRS, and interested congressional committees. In addition, the report is available at no charge on the GAO website at http://www.gao.gov. If you or your staff have any questions about this testimony, please contact me at (202) 512-9110 or whitej@gao.gov. Contact points for our Offices of Congressional Relations and Public Affairs may be found on the last page of this statement. The names of GAO staff who made key contributions to this report are listed in appendix V.

² Our recent report and testimony on large partnerships highlighted their growth and the challenges IRS faces in auditing these entities. See GAO, Large Partnerships: Characteristics of Population and IRS Audits, GAO-14-379R(Washington,D.C.: Mar. 19,2014) and Large Partnerships: Growing Population and Complexity Hinder Effective IRS Audits, GAO-14-746T(Washington,D.C.: July 22, 2014). For details about all partnerships, see GAO, Partnerships and S Corporations: IRS Needs to Improve Information to Address Tax Noncompliance, GAO-14-453(Washington,D.C.: May 14,2014).

³ For this report, we only report data on those partnerships that filed a Form 1065, U.S. Return of Partnership Income, because the database we used to identify large partnerships, the Enhanced Large Partnership Indicator (ELPI) file, does not capture data on large partnerships that filed a 1065-B, U.S. Return of Income for Electing Large Partnerships. For more information see GAO-14-379R.

⁴ IRS does not have a category in its audit data for "large partnerships." To identify the population of large partnership returns that IRS audited, we first identified the number of large partnerships that filed a return and then merged that population with IRS's audit data. Because we focused on large partnership returns filed from tax year 2002 through 2011, returns filed prior to 2002 and then audited by IRS during fiscal years 2007 to 2013 would not be included in the data we report. We report information on a fiscal year basis because IRS reports its tax enforcement information by fiscal year in its annual data book. See IRS Data Book 2013, Publication 55B (Washington, D.C.: March 2014). The fiscal year that the audit closes usually accounts for audit work done in that year as well as prior years.

⁵ Data cover partnerships that filed Form 1065, U.S. Return of Partnership Income, and had 100 or more direct and indirect partners and $100 million or more in assets. Data on the number and characteristics of partnerships are from the Enhanced Large Partnership Indicator and Business Return Transaction File while audit data are from the Audit Information Management System.

⁶ See GAO-14-379R, GAO-14-746T, and GAO-14-453.

⁷ Pub. L. No. 97-248, §§ 401-407, 96 Stat. 324, 648-671 (1982), Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Tax Equity and Fiscal Responsibility Act of 1982, JCS-38-82 (Washington, D.C.: December 1982) and Standards for Internal Control in the Federal Government (GAO/AIMD-00-21.3.1,November 1999).

⁸ For criteria, see GAO, 2020 Census: Additional Steps Are Needed to Build on Early Planning, GAO-12-626(Washington,D.C.: May 17, 2012) and 2010 Census: Cost and Design Issues Need to Be Addressed Soon, GAO-04-37(Washington,D.C.: Jan. 15,2004).

⁹ The guides include: A Guide to the Project Management Body of Knowledge, Project Management Institute Standards Committee, @ 1996, Project Management for Mission Critical Systems, a Handbook for Government Executives, Information Technology Resource Board, Apr. 5, 2001, Capability, Maturity Model Integration Project Planning Guide, Carnegie Mellon Software Engineering Institute, March 2001, and U.S. General Accounting Office, Business Process Reengineering Assessment Guide, GAO/AIMD-10.1.15 (Washington, D.C.: May 1997).

¹⁰ In our March 2014 interim report, we defined a large partnership as having 100 or more direct partners and $100 million or more in assets based on IRS data available on direct partners in the Business Returns Transaction File. See GAO-14-379R. We expanded the partner threshold to 100 or more direct and indirect partners after identifying an IRS data source that captures the number of indirect partners, the Enhanced Large Partnership Indicator file. We used the "$100 million or more in assets" threshold because it is consistent with how IRS's annual study of partnership tax returns being filed segregates partnerships by asset size. See IRS Statistics of Income, Partnership Returns, 2011 (Washington, D.C.: Fall 2013).

¹¹ IRS's Ogden campus services the IRS's Large Business and International division and field audits of large partnership returns.

¹² Pub. L. No. 97-248, §§ 401-407, 96 Stat. 324, 648-671 (1982). TEFRA established unified audit procedures for covered partnerships and, as amended, are found generally at Internal Revenue Code sections 6221 through 6234. A partnership would fall under the TEFRA audit procedures if at any time during the year it had (1) more than 10 partners or (2) certain types of partners (e.g., another partnership, an LLC that files as a partnership or is treated as a single member, LLC disregarded for federal tax purposes, any type of trust, a nominee, a nonresident alien individual, or a S corporation).

¹³ Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Tax Equity and Fiscal Responsibility Act of 1982, JCS-38-82, (Washington, D.C.: December1982).

¹⁴ See U.S. Department of the Treasury, The President's 1978 Tax Program: Detailed Description and Supporting Analyses of the Proposals, (Washington, D.C.: Jan. 30, 1978).

¹⁵ See Treasury and IRS, Widely Held Partnerships: Compliance and Administration Issues -- A Report to Congress (Washington, D.C.: Mar. 30, 1990).

¹⁶ Pub. L. No. 105-34, §§ 1221-1226, 111 Stat. 788, 1006-1020 (1997) (codified at IRC §§ 771-777 and 6240-6242).

¹⁷ ELPs cannot be a partnership engaged in providing services or in buying and selling commodities.

¹⁸ GAO, Internal Revenue Service: Absorbing Budget Cuts Has Resulted in Significant Staffing Declines and Uneven Performance, GAO-14-534R(Washington,D.C.: Apr. 21,2014) and GAO, IRS 2015 Budget: Long-Term Strategy and Return on Investment Data Needed to Better Manage Budget Uncertainty and Set Priorities, GAO-14-605(Washington, D.C.: June 12, 2014)

¹⁹ IRS, "Partnership Returns: Selected Balance Sheet and Income Statement Items, Tax Years 1999-2011, Historical Table 11," Statistics of Income (SOI) Bulletin, http://www.irs.gov/uac/SOI-Tax-Stats-Historical-Table-11 and IRS, "Returns of Active Corporations, Form 1120 and 1120S, Tax Years 2002-2011," Corporation Complete Book, http://www.irs.gov/uac/SOI-Tax-Stats-Corporation-Complete-Report. All estimates derived from samples have 95 percent confidence intervals that are within +/- 10 percentage points of the estimate itself, unless otherwise specified. Calculating percentage changes of numbers presented in above sources may not equal those we present due to rounding.

²⁰ Similar growth is seen when accounting only for direct partners. Our interim report noted that such large partnerships also more than tripled, from 720 in tax year 2002 to 2,226 in tax year 2011, and total assets increased 200 percent over the same time period to $2.3 trillion. See GAO-14-379R. However, when one partnership has an ownership interest in another, the value of that interest is included in the owner's assets. As a result, assets can be counted more than once in a given population of partnerships, such as both asset numbers we report above. We do not know the extent to which the large partnerships in our population hold ownership interests in other partnerships, nor do we know how many of those other partnerships may also be large partnerships, so it is unclear how much less these asset data would be if we excluded the presence of assets being counted more than once.

²¹ This discussion centers on the number of tiers below a given entity, not the number of tiers above it, because the focus is each large partnership structure. This means that these numbers do not indicate whether a partnership is part of the structure of another pass-through entity and is part of a multitiered network.

²² According to IRS officials, although it accounts for a vast majority of the large partnerships, the finance and insurance sector represents a small percentage of all partnerships. Among all partnerships in tax year 2011, almost 50 percent were in the real estate, rental, and leasing group, and 9 percent were in the finance and insurance sector. See IRS Statistics of Income, Partnership Returns, 2011, (Washington, D.C.: Fall 2013).

²³ See GAO-14-746T. Hedge funds and private equity funds are generally available only to institutions and individuals able to invest in excess of $200,000. Aside from the fund managers, who guide the investment strategy and are general partners, the funds' partners would be comprised of these investors who contributed capital but have no say in investment or management decisions and are the limited partners. See Congressional Research Service, Taxation of Hedge Fund and Private Equity Managers, RS22689 (Washington, D.C.: Mar. 7, 2014).

²⁴ IRS defines the audit rate as the number of returns audited in a fiscal year as a percentage of returns filed in the previous calendar year. In calendar year 2011, there were 10,143 large partnership returns filed. For fiscal year 2013, we did not have 2012 calendar year filings at the time of our analysis to be able to compute the audit coverage rate. This 0.8 percent audit rate excluded campus audits because they are not audits of the books and records of large partnerships, or the returns of the related partners, according to IRS officials. If we included campus audits, the audit rate would inflate to 4 percent. IRS includes campus audits in its counts of all partnership audits in publicly available audit data (IRS, Data Book 2013, Publication 55B, Washington, D.C.: March 2014).

²⁵ GAO-14-379R.

²⁶ For taxable entities, such as corporations, changes to net income may result in additional recommended tax liability in the form of additional taxes, penalties, or changes to refundable credits. For pass-through entities, such as large partnerships, changes to net income are changes to the entities' reported income, losses, deductions, or credits reflected on the return or the partners' Schedule(s) K-1.

²⁷ GAO/AIMD-00-21.3.1.

²⁸ These activity codes focus on whether a partnership reported having less or more than 11 partners as well as reported gross receipts above or below $100,000. IRS also has two activity codes for partnerships that pay an entity level tax at the end of an IRS audit, and that had returns processed prior to January 1988.

²⁹ According to IRS officials, these limitations are not restricted to audits of large partnerships.

³⁰See Financial Derivatives: Disparate Tax Treatment and Information Gaps Create Uncertainty and Potential Abuse, GAO-11-750 (Washington, D.C.: Sept. 20, 2011). For more recent information on hedge funds' involvement, see U.S. Senate, Permanent Subcommittee on Investigations, Abuse of Structured Financial Products: Misusing Basket Options to Avoid Taxes and Leverage Limits, (Washington, D.C.: July 22, 2014).

³¹ In some cases, a taxpayer may agree to extend the statute; however, from fiscal year 2007 through fiscal year 2013, 10 or fewer field audits were granted an extension of the statute of limitations each year.

³² TMPs have very limited settlements powers under IRC § 6224(c)(3) and may only bind certain partners that have less than a 1 percent interest in the partnership for partnerships that have more than 100 partners. A partner can be a TMP only if that partner was a general partner at some time during the tax year for which the designation was made or was a general partner at the time the designation was made. Additionally, the TMP must be a U.S. person unless no U.S. person meets the TMP qualifications or IRS consents to a foreign TMP. 26 C.F.R. § 301.6231(a)(7)-1(b).

³³ I.R.C. § 6231(a)(7).

³⁴ See Internal Revenue Manual, section 4.31.2.2.5.1.

³⁵ IRS has defined the withdrawal period as 45 days in the TEFRA regulations. 26 C.F.R. § 301.6223(a)-2(a).

³⁶ The regulation specifies that the 45-day rule starts when IRS notifies the TMP of the partnership audit, which likely occurs after the audit start date. However, IRS does not track this notification date. Thus, we counted how many audits closed within 45 days of the audit start date as a proxy.

³⁷See GAO-14-453.

³⁸ IRC § 704(b) provides partnerships the option to use special allocations. They are generally listed in the partnership agreement that specifies such things as the partnership's name and purpose, partner contributions, and management responsibilities. The agreement is to specify ratios for passing through partnership income, losses, deductions, and credits to the partners.

³⁹ Only 15 ELPs had 100 or more direct partners and $100 million or more in assets in tax year 2011.

⁴⁰ The Chairman of the House of Representatives Committee on Ways and Means's proposal would apply to partnerships with more than 100 direct partners, or if any partner is itself a partnership. See Joint Committee on Taxation (JCT), Technical Explanation of the Tax Reform Act of 2014, A Discussion Draft of the Chairman of the House Committee on Ways and Means To Reform the Internal Revenue Code Title III -- Business Tax Reform, JCX-14-14, (Washington, D.C.: Feb. 26, 2014). The Administration's proposal would apply to partnerships with 1,000 or more direct and indirect partners. See U.S. Department of the Treasury, General Explanations of the Administration's Fiscal Year 2015 Revenue Proposals, (Washington, D.C.: March 2014).

⁴¹ TEFRA Coordinators support field audit team with a number of the administrative steps required by TEFRA, such as qualifying the TMP and closing an audit within 45 days.

⁴² IRS Strategic Plan: FY2014-2017 (Washington, D.C.: 2014).

⁴³ See GAO-14-534R.

⁴⁴ We have previously identified five principles for effective project planning. See GAO-04-37 and GAO-12-626.

⁴⁵ The metrics, which are also used in assessing other audits, are: (1) audit adjustment per staff hour, (2) average months spent on a case, (3) pre-conference hours as a percentage of total case time, (4) total indirect hours as a percentage of total case time, and (5) no change rates. IRS officials also said that they will not be able to determine the effectiveness of changes being tested by the CMT pilot team until the selected returns in the pilot have been audited. As of April 2014, the team projected that these audits would take 18 more months to complete.

⁴⁶ See GAO, Risk Management: Further Refinements Needed to Assess Risks and Prioritize Protective Measures at Ports and Other Critical Infrastructure, GAO-06-91 (Washington, D.C.: Dec. 15, 2005) and Patient Protection and Affordable Care Act: IRS Managing Implementation Risks, but Its Approach Could Be Refined, GAO-12-690 (Washington, D.C.: June 13, 2012).

The objectives of this report are to (1) determine what IRS knows about the number and characteristics of large partnerships; (2) determine what IRS knows about the costs and results of audits of large partnership returns and assess IRS's ability to effectively conduct such audits; and (3) identify and assess IRS's efforts to address the challenges of auditing large partnership returns.

To determine the number and characteristics of large partnerships, we obtained data on tax returns filed by large partnerships from the Enhanced Large Partnership Indicator (ELPI) file on partnerships for tax years 2002 to 2011, and on the number of partnerships with 100 or more direct and indirect partners and $100 million or more in assets. We merged these data with data obtained from the Business Returns Transaction File (BRTF). We analyzed and reported ELPI and BRTF data by the total number of partnerships by asset size, direct partner size, indirect partner size, industry group, and tiering depth. The ELPI data file captures information about the ownership structure of large partnerships. The ELPI file starts with a partnership and traces Schedule K-1 allocations through to the ultimate taxpayer. ELPI traces the ownership structure of a partnership as long as either the depth is less than 11 tiers or the ownership percentage is greater than 0.00001 percent and therefore can present a picture of the approximate number of direct and indirect partners in a partnership structure. The ELPI currently only has data on partnerships that file a 1065 and not those that file a 1065-B. For similar analysis on partnerships that file a 1065-B, see our prior work on large partnerships.¹

To determine the number of IRS audits of large partnership returns and the characteristics of those audits, we obtained data from the Audit Information Management System (AIMS) and reported those partnership returns subject to IRS audit that were closed during fiscal years 2007 to 2013.² Once we identified the audited population of large partnership returns, we only reported those audits that were traditional IRS field audits (in which IRS audited the books and records of a large partnership return), and not campus audits (in which IRS usually passed audit adjustments through to the related partners' returns), as they are mainly an administrative function and do not include an examination of the books and records of the taxpayer return in question. We analyzed the results from these data consistent with how IRS measures audit results, such as the audit coverage rate (partnership returns subject to audit as a percentage of the total partnership return population) and no change rate (those audits that resulted in no change to the tax return from the audit), and, where possible, without suppressing data due to disclosure requirements, by asset size. We also analyzed the hours and days spent on large partnership audits to assess the costs of these audits. Where data were available, we compared these measures for large partnership return audits to those for corporate return audits of the same asset size.

To assess the effectiveness of IRS audits of large partnership returns, we interviewed officials in the Office of Chief Counsel, Large Business and International division, Small Business and Self-Employed division, and Research, Analysis, and Statistics division. We also interviewed a number of external private sector lawyers who are knowledgeable about partnership tax law, reviewed academic research and literature, reviewed IRS documentation, such as IRS policies and procedures on partnership audits, and reviewed our recent reports on partnerships.³ We also completed six focus groups with 30 IRS team coordinators and managers on the challenges associated with completing audits of large partnership returns. These team coordinators and managers were selected for our focus groups because they supervised or worked on a large partnership return audit, based on our definition of large partnerships above, which was closed in calendar year 2013. Where available, we supplemented the challenges identified in these focus groups with supporting data and documentation to provide context or support those challenges identified. We performed a content analysis on the six focus groups, using NVivo software, to analyze and categorize the themes of the focus groups.⁴ The results of the focus group data are not generalizable to all IRS audits and do not necessarily represent the official viewpoint of IRS. Instead the results are used to identify themes in conjunction with the other data we collected. We compared information available to the intent of the partnership audit procedures outlined in statute.⁵ In addition, we compared information available on audits of large partnership returns to Standards for Internal Control in the Federal Government (GAO/AIMD-00-21.3.1, November 1999).⁶

To identify and assess IRS efforts to address the challenges of audits of large partnership returns, we reviewed IRS documentation and interviewed IRS officials to identify any efforts and initiatives they have ongoing related to large partnership. We assessed IRS's efforts and initiatives related to large partnerships using project planning criteria that our prior work identified work as leading practices.⁷ We identified these criteria by conducting a literature review of a number of guides on project management and business process reengineering.⁸

For the purposes of this review, we determined that the data used in our analysis were sufficiently reliable for our purposes and all dollar values have been adjusted for inflation to tax year or fiscal year 2014. Our data reliability assessment included reviewing relevant documentation, conducting interviews with knowledgeable IRS officials, and conducting electronic testing of the data to identify obvious errors or outliers. All Statistics of Income estimates in this report have 95 percent confidence intervals that are within +/- 10 percent of the point estimate, unless otherwise specified. Based on IRS documents and interviews with IRS officials, data in the ELPI file may be incomplete since this file is based on Schedule K-1 data. For example, some Schedule K-1s may be missing from the database because partnerships did not file Schedule K-1s, IRS errors, and timing problems. In general, the depth of tiering in ELPI for a partnership structure represents a minimum amount resulting in approximate entity counts because the missing data would add more entities that qualify for our definition of large partnerships.

We conducted this performance audit from October 2013 to September 2014 in accordance with generally accepted government auditing standards. Those standards require that we plan and perform the audit to obtain sufficient, appropriate evidence to provide a reasonable basis for our findings and conclusions based on our audit objectives. We believe that the evidence obtained provides a reasonable basis for our findings and conclusions based on our audit objectives.

² IRS compiles and reports data from audits by predefined codes, known as activity codes. While IRS segregates its corporate audits by activity codes for the corporation's reported asset size, IRS does not segregate its audits of partnerships in this manner and the codes are generally less granulated than those that exist for corporations. As a result, IRS's activity codes do not have a category for "large partnerships." Therefore, to identify the population of large partnership returns subject to IRS audit, we had to merge data in ELPI and BRTF to data AIMS. Since we only identified the population of large partnerships in ELPI and BRTF going back to 2002, the data we report from AIMS on the audited population of returns do not include returns that were filed before 2002. For example, if a return was filed prior to 2002 and then audited by IRS during fiscal years 2007 to 2013, it would not be included in the data we report. We report information on a fiscal-year basis because IRS reports its tax enforcement information on a fiscal year basis in its annual data book. See IRS, Data Book 2013, Publication 55B (Washington, D.C.: March 2014). The fiscal year in which the audit is closed is not necessarily representative of the audit activity levels or the audit results for the year of the closure. In many cases, the audits were initiated and the majority of the audit work was done in prior years.

³ Our recent report and testimony on large partnerships highlighted their growth and the challenges IRS faces in auditing these entities. See GAO, Large Partnerships: Characteristics of Population and IRS Audits, GAO-14-379R (Washington, D.C.: Mar. 19, 2014) and Large Partnerships: Growing Population and Complexity Hinder Effective IRS Audits, GAO-14-746T (Washington, D.C.: July 22, 2014). For details about all partnerships, see GAO, Partnerships and S Corporations: IRS Needs to Improve Information to Address Tax Noncompliance, GAO-14-453 (Washington, D.C.: May 14, 2014).

⁴ NVivo is a qualitative data analysis software system that allows organization and analysis of information from a variety of sources including complex nonnumeric or unstructured data.

⁵ Pub. L. No. 97-248, §§ 401-407, 96 Stat. 324, 648-671 (1982) and JCT, General Explanation of the Revenue Provisions of the Tax Equity and Fiscal Responsibility Act of 1982, JCS-38-82, (Washington, D.C.: December 1982).

⁶ GAO/AIMD-00-21.3.1.

⁷ GAO, 2020 Census: Additional Steps Are Needed to Build on Early Planning, GAO-12-626 (Washington, D.C.: May 17, 2012) and 2010 Census: Cost and Design Issues Need to Be Addressed Soon, GAO-04-37 (Washington, D.C.: Jan. 15, 2004).

⁸ The guides include: A Guide to the Project Management Body of Knowledge, Project Management Institute Standards Committee, @ 1996, Project Management for Mission Critical Systems, a Handbook for Government Executives, Information Technology Resource Board, April 5, 2001, Capability, Maturity Model Integration Project Planning Guide, Carnegie Mellon Software Engineering Institute, March 2001, and U.S. General Accounting Office, Business Process Reengineering Assessment Guide, GAO/AIMD-10.1.15 (Washington, D.C.: May 1997).

Thank you for the opportunity to review and provide comments on your draft report entitled, Large Partnerships: With Growing Population, IRS Needs to Improve Audit Efficiency (GAO-14-732). We appreciate the considerable time your team has spent in reviewing activities of large, widely-held partnerships under this engagement, as well as under the prior report (GAO-14-379R) and testimony (GAO-14-746T). The objectives were to:

Your findings indicate needs for improvements and we appreciate your recommendations. Enclosed is our response to these recommendations.

If you have any questions, please contact Pasquale Angelillo, Acting Director, PAIR at (630) 493-5926.

RECOMMENDATION 1:

Track the results of the large partnerships audits: (a) define a large partnership based on asset size and number of partners; (b) revise the activity codes to align with the large partnership definition; and (c) separately account for field audits and campus audits.

MANAGEMENT RESPONSE:

We agree with this recommendation. However, the revision of Partnership Activity Codes is dependent upon future funding.

RECOMMENDATION 2:

Analyze the audit results by these activity codes and types of audits to identify opportunities to better plan and use IRS resources in auditing large partnerships.

MANAGEMENT RESPONSE:

We agree with this recommendation. However, the revision of Partnership Activity Codes is dependent upon future funding.

RECOMMENDATION 3:

Use existing authority to promptly designate the TMP under the largest profits interest rule or some other criterion.

MANAGEMENT RESPONSE:

We agree with this recommendation.

RECOMMENDATION 4:

Extend the 45-day rule to give field audit teams more flexibility on when to withdraw an audit notice.

MANAGEMENT RESPONSE:

We agree with this recommendation.

RECOMMENDATION 5:

To help field auditors for large partnership audit receive the support they request from Counsel staff, TEFRA coordinators, and IRS specialists, (a) track the number of requests and time taken to respond; (b) clarify when responses to their request should be expected; and (c) use the information when planning the number and scope of large partnership audits.

MANAGEMENT RESPONSE:

We agree with this recommendation.

RECOMMENDATION 6:

Clarify how and when field auditors can access refresher training on TEFRA audit procedures and partnership tax law.

MANAGEMENT RESPONSE:

We agree with this recommendation.

RECOMMENDATION 7:

Develop and implement large partnership efforts in line with the five leading principles for project planning and track the results to identify whether the efforts worked as intended.

MANAGEMENT RESPONSE:

We agree with this recommendation.

RECOMMENDATION 8:

Make and document a determination of how large partnerships are to be incorporated into Enterprise Risk Management process.

MANAGEMENT RESPONSE:

IRS agrees to further study whether opportunities exist for risk management principles and practices in general to be used to help support resource and compliance decisions, such as determining or assessing risks associated with working large partnerships or other types of returns.

In addition to the contact listed above, Tom Short, Assistant Director; Vida Awumey; Sara Daleski; Deirdre Duffy; Robert Robinson; Cynthia Saunders; Erik Shive; Albert Sim; A.J. Stephens; and Jason Vassilicos made key contributions to this report.

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