The IRS' Growing Scrutiny of Partnership Audits
It is obvious what the IRS is doing with the new information required on partnership tax returns and schedule K-1s.
As a tax professional, it is easy to feel like we are getting mixed signals from the Internal Revenue Service. On the one hand, we hear about tax return processing backlogs that we have not seen in our lifetime. Even as we are smack in the middle of the 2021 tax return filing season, millions of 2020 tax returns sit unprocessed. The frustrations are not only on the individual side. Calls to the IRS to resolve net operating loss carryback claims, resolve payment issues, or resolve notices are arduous at best. The Taxpayer Advocate Service, an independent organization within the IRS, has received unprecedented requests for assistance from the public, and that does not seem to be waning.
On the other hand, and specifically as it relates to partnership tax returns, we are in the golden age of tax transparency whereas each year the IRS seems to require more and more information regarding the tax returns being filed. The question begs, “What is the IRS doing with all this information?” Before we answer that, let’s take a moment and run down the recent requirements:
- Partner built- in gain reporting added to schedule K-1s for 2019 tax returns
- The tax capital reporting requirement originally planned for 2018 tax returns has been delayed to 2020 tax returns
- Increased foreign reporting requirements with the introduction of schedule K-2/K-3 for 2021 tax returns but delayed to 2022 tax returns for some taxpayers
- Partners step-up information became more detailed on 2020 tax returns
Of course, these changes, which coincide with the new partnership audit rules that came into play in 2018, most certainly will provide the IRS with an audit road map. The centralized partnership audit regime, or Bipartisan Budget Act (BBA), generally became effective for tax years beginning January 2018. Under the BBA, the IRS generally assesses and collects any understatement of tax at the partnership level. A partnership is subject to BBA unless it is an eligible partnership that makes an election out of the rules. An eligible partnership is one with 100 or fewer partners, all of whom are either individuals, C corporations, S corporations or estates of deceased partners. A partnership with another partnership as a partner would not be an eligible partnership.
Given that the BBA provides the IRS with a better mechanism to assess and collect tax, it is obvious what the IRS is doing with the new information required on partnership tax returns and schedule K-1s. The IRS will have better visibility into gain recognition on distributions in excess of basis or reduction of allocated liabilities, taxable income and loss allocations, and foreign ownership of domestic assets. Accordingly, one BBA audit could not only result in tax assessed at the partnership level (as an aside, the partnership could make a “push-out” election to push the tax to taxpayers who were partners for the tax year assessed) but also lead to further audits of the partners.
So, what then is the status of impending partnership audits? Over the summer of 2021, the IRS launched a new large partnership audit program, and most recently, in March 2022, the IRS began increasing its staff by adding partnership tax experts. This isn’t lip service from the IRS as we have already seen several large partnership audits initiated over the last few months. In fact, operating partnerships of public REITs seem to be a target. This is mildly interesting in that REITs are majority owners of the operating partnerships and do not themselves pay income tax (to the extent they distribute income). Of course, any adjustments to increased income could cause issues for REITs. More so, though, there are many complicated issues, including deferred and built-in gains, that directly impact REIT executives and other real estate professionals. At the very least, this will create a huge time and money commitment in navigating through the audits. In fact, all large partnerships will be seeing an increase in tax professional fees as it relates to increased information reporting–something that will be important as the audit activity increases.
Stephen Bertonaschi is a senior managing director in the Business Tax Advisory group within the real estate practice at FTI Consulting. Scott Drago is a managing director in the Business Tax Advisory group. FTI Consulting is an independent global business advisory firm.