The growing number and complexity of large partnerships, such as hedge funds, are making it difficult for the Internal Revenue Service to audit them effectively, according to a new government report.

The report, from the Government Accountability Office, follows on the heels of an earlier GAO report this spring indicating that the IRS is performing more audits of large partnerships, but only a relatively tiny fraction of the growing population (see IRS Doing More Audits of Large Partnerships). The GAO defines large partnerships as those having $100 million or more in assets and 100 or more direct and indirect partners. Businesses organized as partnerships have increased in number in recent years while the number of C corporations (that is, those subject to the corporate income tax) has decreased.

In the latest report, released Tuesday, the GAO cited IRS data showing that from tax years 2002 to 2011, the number of large partnerships more than tripled. According to IRS officials, many large partnerships are hedge funds or other investment funds where the investors are legally considered partners. Many others are large because they are tiered and include investment funds as indirect partners somewhere in a tiered structure. According to IRS data, there were more than 10,000 large partnerships in 2011. A majority had more than 1,000 direct and indirect partners although hundreds had more than 100,000. A majority also had six or more tiers, the GAO noted.

The report was produced for a hearing Tuesday of the Senate Subcommittee on Investigations, which has been looking into tax deals that the hedge fund Renaissance Technologies LLC set up with the help of Barclays and Deutsche Bank that may have enabled investors to avoid more than $6 billion in U.S. income taxes (see Renaissance Avoided More than $6 Billion Tax, Senators Say).

The GAO said the IRS audits few large partnerships—0.8 percent in fiscal year 2012 compared to 27.1 percent for large corporations. Of the audits that were done, about two-thirds resulted in no change to the partnership's reported net income. The remaining one-third resulted in an average audit adjustment to net income of $1.9 million.

The structure of large partnerships varies. Some large partnerships have direct partners that are partnerships and may bring many of their own partners into the structure. By “tiering” partnerships in this manner, very complex structures can be created with hundreds of thousands of direct and indirect partners. Tiered large partnerships are challenging for the IRS to audit because of the difficulty of tracing income from its source through the tiers to the ultimate partners.

“These minimal audit results may be due to challenges hindering IRS's ability to effectively audit large partnerships,” said the report.

The challenges included administrative tasks required by the Tax Equity and Fiscal Responsibility Act of 1982, or TEFRA, and the complexity of large partnership structures due to tiering and the large number of partners.

For example, IRS auditors said that it can sometimes take months to identify the person who represents the partnership in the audit, as required by TEFRA, reducing the time available to conduct the audit. Complex large partnerships also make it difficult to pass through audit adjustments across tiers to the taxable partners.

In addition, a three-year statute of limitations governs the time IRS has to complete partnership audits, according to the audit procedures enacted in TEFRA. The first stage is the period from when a return is received until IRS begins the audit. The second stage is the period in which the IRS conducts the audit. The third stage is when the IRS assesses the partners their portion of the audit adjustment.

The IRS cannot resolve some of the challenges because they are rooted in tax law, such as those required by TEFRA, according to the GAO. Congress and the Obama administration have proposed statutory changes to the audit procedures for partnerships, such as requiring partnerships to pay taxes on net audit adjustments rather than passing them through to the taxable partners.

In addition, the IRS has implemented some changes to its large partnership audit process, such as understanding the complexity of large partnerships and selecting returns for audits.

The GAO made no recommendations in the report, but plans to issue a report later this year assessing the IRS's large partnership audit challenges. The IRS provided technical comments, which were incorporated in the report.