Is the new audit regime easier for the IRS to enforce and for practitioners to advise clients about? Michael Greenwald, partner with Friedman LLP, discusses this topic with Bloomberg BNA to share the complexities of auditing partnerships.
The IRS could focus audit efforts on small, multi-tiered partnerships with lots of revenue under a new audit regime introduced in a budget bill moving through Congress.
The Internal Revenue Service will probably look at “smaller tiered partnerships, with three, four or five layers, where it is uncertain as to where the deductions are finally ending up and where the income is deferred,” Michael J. Greenwald, a partner at Friedman LLP in New York, said Oct. 28. “When you look at the provisions and who is most affected, it's not large single-tiered partnerships with thousands of partners.”
Provisions in the budget deal make it easier for the IRS to audit partnerships by collecting tax adjustments at the entity level, rather than from individual partners. Partnerships have been audited at much lower rates than corporations in the past, because of the time and expense the government would have to spend looking at returns and collecting payment from partners in a complicated structure (208 DTR G-2, 10/28/15).
The IRS, amid resource shortages, will likely look for places where it thinks revenue is hiding, Greenwald told Bloomberg BNA. “There is a sense that the IRS will probably not go after all large partnerships. There are a lot of partnerships that are ‘small' in terms of number of partners where there are a lot of revenue and deductions,” he said.
The tangible property regulations (T.D. 9689), which were fully implemented in 2014, are one example where small partnerships were able to take big deductions on expenses tied to real property, such as installing a new roof on an apartment building or replacing tires on a truck. The comprehensive but complex rules laid out a framework for how to deduct repair expenses and capitalize improvements.
The new audit structure would simplify the processes for how partnerships are audited because the IRS will “not be herding cats” and will instead “deal with the cat herder,” Steven R. Schneider, a partner at Goulston & Storrs PC, told Bloomberg BNA. The regime would also make it easier for practitioners to convince clients to do the right thing if they know someone will be looking over their shoulder, he said.
“Respectable practitioners like a little bit of policing,” Schneider said. “They don't want to be the only one telling the client, ‘Don't do that.' ”
The rate at which partnerships are audited is expected to increase under the new regime, though exactly how much depends on funding levels at the IRS. Agency officials have said they aim to audit partnerships at a similar rate as C corporations (39 DTR G-6, 2/27/15).
The IRS audit rate for large partnerships has been less than 1 percent in recent years. Similarly sized C corporations are typically audited at rates between 25 percent and 30 percent.
The time and effort the IRS will need to spend auditing each partnership will decrease, but the agency doesn't have a deep bench of auditors who specialize in the intricacies of Subchapter K, and might not be able to recruit more without additional funding. Without new staff, the IRS could opt to shift resources away from individual or corporate audits, which could decrease the funds garnered from audits in those areas.
“If you don't fully fund the IRS, you're just rearranging deck chairs on the Titanic,” Greenwald said. “It's scored to raise $11.2 billion, but if it is merely shifting resources within the IRS, it is really only a revenue raiser in isolation.”
Preparation Begins Now
The new regime is expected to go into effect in 2018, giving practitioners two years to review partnership agreements for clients and for their own firms, which in many cases are structured as pass through entities. Partnership agreements are rarely touched after they're written, Schneider said.
The new audit process doesn't require the IRS to notify every partner about an audit. All communication will go through a point person selected by the firm, much like how the IRS doesn't inform all C corporation shareholders about issues.
“We don't think of a partnership as a corporate model,” Schneider said. “Contractually, it's going to force me to say in the agreements, “You're going to have to keep me in the loop.” I would generally put that in there anyway, but now I'm going to be even tighter in that language.”