The Treasury Inspector General for Tax Administration (TIGTA) announced today that the number of partnership audits has increased by nearly 25% from 2007 to 2011. In addition, a renewed focus on transactions involving payees across borders resulted in audits netting $2.1 billion in additional taxes.

In terms of the domestic focus on these audits there are not only greater numbers of audits targeted at partnerships, but these audits also ultimately recommended approximately $728 million in adjustments to items reported on the returns. However, domestic numbers numbers pale when compared to the dollar amount recovered from IRS examiner's work on international transactions.

According to the IRS, the compliance risk associated with international tax transactions involves significant tax revenues and presents tax administration challenges as businesses continue to expand operations across international borders and engage in international transactions.  In FY 2011, IRS examiners spent over 235,000 hours on international audits and recommended that business entities pay almost $2.1 billion in additional taxes.

As for domestic partnership examinations; these are part of an IRS effort to select returns for audit that its examiners believe are more likely to find areas of noncompliance and recommend changes to one or more items reported on the return.  One IRS audit source is the Discriminant Index Function (DIF) system; used to help decide how to best allocate its audit resources.  The system uses mathematical formulas to calculate and assign a score to returns based on their audit potential.  The higher the score, the greater the chance an audit will result in recommended changes to the return. Partnerships have traditionally been a source of concern because of some taxpayers use of partnerships as a vehicle to take advantage of unintended loopholes in the tax laws. A further look at partnerships explains how such tax avoidance happens.

Partnerships are associations of two or more persons or entities, such as corporations or other partnerships that join to carry on a trade or business.  Each partner generally contributes money, property, labor, or specialized skills in exchange for a share of the profits and losses from the partnership.  Although partnerships are required to annually file Form 1065, U.S. Return of Partnership Income, no taxes are paid with these tax returns.  The partners are responsible for reporting and paying any applicable taxes on their respective income tax returns for their share of the partnership’s income.  Because the partnership distributes untaxed income, losses, credits, and other tax items to the respective partners, partnerships are commonly referred to as flow-through entities. 

Unfortunately, partnerships have provided a very popular way to shelter income from taxation because they have minimal legal startup formalities and costs, as well as the legal capacity to pass on to their partners losses that can be used to offset wages and other income sources of the partners.  Changes in the legal and regulatory environment in the 1990s contributed to making partnerships one of the fastest growing segments of all tax returns filed.  As such the IRS aggressively audits partnerships at both the entity level (under a set of procedures stemming from the the Tax Equity and Fiscal Responsibility Act of 1982), and for partnerships not subject to the 1982 Act's rules audits are done separately for each individual partner's return. Either way, if you are a partnership worried about your IRS compliance risks then it is far better to be proactively prepared then to sit back and await what is very likely to be an impending IRS audit.