The Internal Revenue Service is being asked to do more to crack down on tax noncompliance by partnerships and S corporations, including requiring more of them to file their tax returns electronically.

A new report from the Government Accountability Office notes that the full extent of partnership and S corporation income misreporting is unknown. The IRS’s last study of S corporations, using data from 2003 and 2004, estimated that these entities annually misreported approximately 15 percent of their income, an average of $55 billion for 2003 and 2004. The IRS does not have a similar study for partnerships.

Using IRS data and the study results, the GAO derived a rough-order-of-magnitude estimate of $91 billion per year of partnership and S corporation income being misreported by individuals for 2006 through 2009.

Since 1980, partnerships’ and S corporations’ share of business receipts increased greatly, the GAO pointed out. These entities generally do not pay income taxes. Instead, income or losses (which can amount to hundreds of billions of dollars annually) flow through to partners and shareholders to include on their income tax returns. The GAO has previously reported that the misreporting of income by partners and shareholders poses a tax compliance risk.

IRS examinations and automated document matching have not been effective at finding most of the estimated misreported income, the GAO noted in the new report. For example, the IRS reported that examinations identified approximately $16 billion per year of misreporting in 2011 and 2012, the bulk of which related to partnerships. However, the GAO acknowledged that the information about compliance results is unreliable. The IRS itself estimated that between 3 and 22 percent of the misreporting by partnerships was double-counted due to some partnership income being allocated to other partnerships or related parties.

In addition, the IRS does not know how income misreporting by partnerships affects taxes paid by partners, and the IRS does not have a strategy to improve the information. As a result, the IRS does not have enough reliable information about its compliance results to fully inform the agency’s decisions about allocating examination resources across different types of businesses.

Nevertheless, the GAO found that the IRS's processes for selecting returns to examine could be improved. Not all partnership and S corporation line items from paper returns are digitized, the GAO noted, and IRS officials said that having more return information available electronically might improve examination selection.

In 2011, approximately 65 percent of partnerships and S corporations electronically filed their tax returns. Certain large partnerships and S corporations are required by statute to e-file. The GAO said that expanding the e-file mandate would increase the amount of digitized data available for examination selection.

In 1995 the GAO found that the IRS's computerized scoring system for selecting partnership returns to examine used outdated information. The IRS still does not have a strategy to update and use this information to select partnerships for examination. Relatively few partnerships are examined compared to other business entities, and many examinations result in no change in taxes owed.

“Improved examination selection based on more current information could generate more revenue and reduce IRS examinations of compliant taxpayers,” said the GAO.

The GAO suggested that Congress consider requiring more partnerships and corporations to e-file their tax returns. The GAO recommended, among other things, that the IRS develop a strategy to improve its information on the extent and nature of partnership misreporting, and use the information to potentially improve how it selects partnership returns to examine.

The IRS said it would consider all the GAO’s recommendations and identify appropriate actions. However, IRS officials pointed to the budget constraints under which the agency is operating.

“Auditing partnership and S corporation returns remains a priority area for the IRS given the increased filing activity in this area,” wrote IRS deputy commissioner for services and enforcement John M. Dalrymple in response to the report. “However, budget reductions over the past few years have severely limited our work in this area and will continue to impact what actions we are able to complete.”

He pointed out that the report did acknowledge the progress the IRS has made in its partnership enforcement efforts, including using filters to test new workload selection techniques.

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