Pass-Through Entity Audits on the Rise
By Katherine Krafchuk, CPA, Senior Manager, Alternative Investment Group
Pass-through entities (partnerships, limited liability companies, and s-corporations) have come to the forefront of the Internal Revenue Service (“IRS”) in its continuing efforts to focus on high-wealth individuals. With the exponential increase in the number of large partnership returns filed with the IRS over the past few years, the IRS is betting on its increased attention to pass-through entities to help find non-compliant taxpayers. Recently, the United States Government Accountability Office, along with the IRS, have issued news releases and a GAO report; IR 2023-166, IR 2023-172, IR 2023-176, and GAO-23-106020 announcing the government findings, recommendations, and plans to increase and enhance the coverage of large partnership audits. With financial services comprising roughly 72% of all large partnership returns filings, the alternative investment industry may see a significant increase in IRS audits and tax compliance letters. Therefore, thoughtful planning of potential complex tax issues should be looked at thoroughly before finalizing business transactions.
What is the IRS’s Large Business and International Division
The IRS formed its Large Business and International Division (“LB&I”) to focus on tax administration activities for domestic and foreign businesses with assets exceeding $10 million or more. The LB&I is also responsible for managing the Global High Wealth and International Individual Compliance programs within the IRS.
As a result of the additional funding from the Inflation Reduction Act (“IRA”) passed in August 2022, the IRS released IR 2023-176 on September 20, 2023, explaining how it has expanded the LB&I and established a special practice area within LB&I to focus on large and complex pass-through entity tax returns. Danny Werfel, the IRS Commissioner, is hopeful that “this is another part of our efforts to ensure the IRS holds the nation’s wealthiest filers accountable to pay the full amount of what they owe.” With part of its funding from the Inflation Reduction Act, the IRS opened more than 3,700 mid-career positions nationwide to focus attention on these complex partnerships, large corporations, and high-income and high-wealth individuals.
The IRS’s initial efforts
Since 2017, with the passing of the Bipartisan Budget Act Centralized Partnership Audit Regime (allows for audit adjustments to be the responsibility of the partnership rather than at the individual partner level), the IRS has continued its efforts in making partnership audits more efficient since large partnership returns pose its own set of unique challenges to the IRS with their complex tiered ownership structures, circular ownerships, and regulations being among the most intricate in the Internal Revenue Code. In 2021, the IRS continued its focus on identifying high-risk issues within the partnership return filings by launching the Large Partnership Compliance pilot program (“LPC”) through the LB&I. With the help of data analytics, the LPC’s main goals are to help identify partnership return pools, identify, and assess the compliance risk of the population pools, consider examination processes and tools that will help understand the audit population, and lastly, enhance the IRS’s understanding of large partnership compliance issues through feedback. Since the implementation of the LPC, large partnerships generally having more than $10 billion in assets on average in industries including hedge funds, real estate investment partnerships, publicly traded partnerships, large law firms, and other sectors, have been looked at closely. However, the IRS hopes to expand these pools to a broader set of taxpayers that fall within the LB&I threshold.
The IRS’s current efforts
With its hopes of finding high-risk taxpayers and non-compliance, the IRS released IR 2023-166, confirming it has started to leverage the use of Artificial Intelligence (“AI”) within its LPC program. Its hope in adding AI, along with the hiring of additional agents, is to gain an even better understanding of high-risk areas within large partnership structures and tax issues currently present. The IRS also confirmed it was opening 75 examinations within the large partnership pool and aims to mail correspondence to an additional 500 partnerships beginning October 2023, with their sights set on increasing their additional audit stream. By leveraging AI, the IRS expressed that it would help to limit the needless “no-change” audits and help focus the department assets on finding more non-compliance issues. Furthermore, with the increase of IRS correspondence letters and review of the responses to these letters, the agency can now quickly assess and determine if an audit is warranted. The IRS is making big bets that AI will help bring additional efficiency to the IRS’s audit procedure.
The IRS has recently disclosed that its strategies to combat non-compliance are working. With the launch of the LPC, the LB&I recently disclosed its findings regarding its most non-compliant taxpayers resulting from their high-risk audits. The findings explained taxpayers who had returns with large balance sheet discrepancies and no disclosures were most likely high-risk. Therefore, the IRS has requested taxpayers provide proper disclosures on return discrepancies. By taxpayers providing additional disclosures, the IRS hopes to mitigate unnecessary letters being sent to taxpayers and allow the department resources to be utilized elsewhere.
Taxpayers that fall within the LB&I threshold of having assets of $10 million or more should start considering the likelihood of an increased chance of an audit or additional tax correspondence from the IRS. Pass-through entity taxpayers should also be proactive in planning potential business transactions and any other tax compliance that may come with it. For more information regarding the increased focus on pass-through entity returns or assistance with additional tax planning or needs, Marcum’s team of professionals is available to help mitigate the risk of IRS audit adjustments.