The Internal Revenue Service needs to make further improvements in how it audits partnership tax returns, including assessing how much additional tax the partners owe after a partnership return is audited, according to a new government report.

The report, from the Treasury Inspector General for Tax Administration, found that improvements are needed to measure the success and productivity of the IRS’s partnership audit process and to ensure that taxable partners are assessed the correct tax.

Partnerships are required to file a Form 1065, indicating the partnership’s income, loss, gains, deductions, and credits, but the partnerships are not taxed directly, the report pointed out. Instead, the partners are responsible for reporting their share of partnership items on their respective tax or information returns.

But since fiscal year 2010, the IRS has failed to assess taxable partners approximately $14.5 million in taxes, interest and penalties resulting from audits of partnership returns.

TIGTA initiated its audit to identify the types of noncompliance the IRS has detected among partnerships and evaluate the progress the IRS has made toward addressing this noncompliance.

The report found that the IRS has indeed taken actions to help improve the partnership audit process. However, due to the complexity of many partnerships, it is difficult for the IRS to evaluate the ultimate effect of its audit activity on the tax liability of partners.

"While partnership audits have resulted in billions of dollars in partnership audit adjustments, the IRS does not know how much additional tax is ultimately assessed to the taxable partners as a result of the adjustments made to the partnership returns," said TIGTA Inspector General J. Russell George in a statement.

TIGTA found that the IRS does not have a process to adequately measure the performance of the function responsible for assessing tax to certain partners. The lack of adequate performance measures and the fact that it has been more than 20 years since the IRS conducted a comprehensive compliance study on partnerships is a concern for TIGTA.

Without this information, the report noted, it is difficult to gauge the productivity and success of the IRS’s partnership audit process. There have been legislative proposals designed to help streamline auditing large partnerships that may help mitigate some of the challenges of these audits.

TIGTA recommended that the IRS develop a strategy to measure the success and productivity of all partnership audits, and develop a system that will determine the amount of taxes assessed as a result of all partnership audits. The IRS should also ensure that audit closing and assessment efforts are included in productivity measurements, the report suggested. TIGTA also suggested that the IRS update its audit report-writing software to accommodate certain types of adjustments and calculations to avoid inaccurate assessments. The IRS should also coordinate with the Treasury Department to assess the impact that proposed changes to the tax laws would have on the IRS’s partnership audit process, according to the report.

IRS officials agreed with all five recommendations and stated that they plan corrective actions to address two of the recommendations. However, IRS officials also said they could not commit to making the recommended improvements for the remaining three recommendations because of a lack of available funding. The IRS’s fiscal year 2016 budget request did not include funding for a new system to address the issues discussed in the report, and TIGTA warned that the problems would remain and possibly increase in scope.

Karen Schiller, commissioner of the IRS’s Small Business/Self-Employed Division, pointed out in her response to the TIGTA report that the Tax Equity and Fiscal Responsibility Act of 1982, also known as TEFRA, created a unified audit procedure for all partnerships, aside from those that met a “small partnership” exception. “The law and the resulting administrative were sufficient to deal with the small number of partnerships in existence at that time, most of which were relatively simple in structure,” she wrote. “Over 30 years have passed since     TEFRA’s enactment and the landscape of partnerships as an operating vehicle has changed and expanded dramatically. In 1982, the enactors of TEFRA could not have anticipated the current complex nature and multi-tier entity structures that are utilized today as investment vehicles to raise and allocate capital. … The evolution of partnerships since the creation of TEFRA has impacted our ability to efficiently process partner adjustments related to large partnership audits.”

An IRS spokesperson emailed a further statement to Accounting Today on the report Tuesday. “While the success in productivity of the partnership audit process is a priority for the IRS, a dramatic increase in the complexity and structuring of partnerships over three decades has generated significant challenges in this audit process,” said the IRS. “In the last 10 years, partnership returns have increased 47 percent and now exceed 3.6 million. Under the current law, the IRS must notify each partner at the beginning of an audit and require all partners to amend their tax returns based on any audit adjustment. Since many partnerships have thousands of partners, this translates to thousands of amended schedules and returns.

“As TIGTA also acknowledged, legislative changes are needed to effectively address the challenges faced in the tax administration of partnerships,” the IRS statement continued. “As TIGTA notes, the IRS has taken several actions to improve the partnership audit process, including the establishment of a partnership council to address the most pressing issues in this important area.

“Budget constraints limit our ability to make all the necessary improvements in the partnership area,” the IRS added. “Since 2010, the IRS’s budget has been reduced nearly $1.2 billion and we expect to have at least 16,000 fewer employees by the end of the year.”

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