Significant Changes to Partnership Tax Audits Coming in 2018

David J. Moise and Jill E. Misener

In less than six months, on January 1, 2018, the new centralized partnership audit rules enacted by Congress as part of the Bipartisan Budget Act of 2015 (“BBA”) will go into effect. The new rules were drafted in response to the proliferation of business entities that are taxed as partnerships (such as LLCs), and the perceived difficulty in being able to both effectively audit these entities and to assess and collect tax from the individual parties as appropriate.

The BBA creates a new partnership audit regime that significantly changes the procedures for partnership audits under the Tax Equity and Fiscal Responsibility Act (“TEFRA”) and the special rules for Electing Large Partnerships (“ELP”). Under the new rules, tax adjustments resulting from partnership examinations will generally be assessed at the partnership level rather than the individual partner level. This enables the IRS to collect tax due on partnership adjustments at the entity level, effectively imposing an entity level tax on partnerships. Previously, under TEFRA, adjustments to partnership items were determined in a single proceeding at the partnership level, but then flowed through to partners pursuant to a complex set of rules requiring significant IRS time and effort. The new rules are intended to simplify the complexity of the current partnership audit rules, and increase the ability of the IRS to examine partnerships, particularly large and tiered partnerships. Continue reading

TIGTA Releases Annual Report on IRS Compliance Trends

The Treasury Inspector General for Tax Administration (TIGTA) released its annual report on IRS compliance trends yesterday.  The key takeaway from the report is TIGTA’s finding that the total amount of revenue received and collected by the IRS increased for the third year running, despite the fact that the IRS had fewer employees and decreased funding levels.  However, the IRS conducted fewer examinations, and its Collection function continued to receive more delinquent accounts than it closed, the report concluded.

“Budget reductions contributed to a decrease in the number of examinations and an increase in the number of delinquent taxes being assigned to an inactive status at the Internal Revenue Service last year,” said J. Russell George, Treasury Inspector General for Tax Administration.  “However, overall enforcement revenue increased in 2013, due, in part, to several large appeal case settlements.”

Here are the key findings of TIGTA’s report:

  • The Internal Revenue Service’s appropriated budget decreased 7.4 percent between FY2010 and FY2013, from $12.1 billion to $11.2 billion after sequestration.  The budget cuts resulted in reductions in the number of employees available to provide services to taxpayers and enforce the tax laws.  Specifically, the number of full-time equivalents dropped by nearly 9 percent, from 94,618 at the end of FY2010 to 86,310 at the end of FY2013, including a 4 percent reduction between FY2012 and FY2013.  The number of enforcement personnel decreased by more than 1,000 employees during FY2013.
  • Despite these challenges, total dollars received and collected (gross collections) increased for the third straight year to $2.9 trillion (a 13 percent increase) in FY2013.  Enforcement revenue collected also increased from $50.2 billion in FY2012 to $53.3 billion in FY2013, due, in part, to several large Appeals case settlements.  Tax return filings continued to increase as did gross accounts receivable, which increased to $400 billion.
  • TIGTA found that the FY2013 Collection function activities showed mixed results. The amount collected on delinquent accounts by both the Automated Collection System and Field Collection decreased.  The Collection function continued to receive more delinquent accounts than it closed, although the number of delinquent accounts in the Collection queue decreased, due in part to the shelving of millions of accounts that were not resolved.  Fewer Notices of Federal Tax Lien were filed, fewer levies were issued, and fewer seizures were made.  Meanwhile, taxpayers’ use of payment options such as offers in compromise increased.

TIGTA’s report found that IRS Examination function conducted 6 percent fewer examinations in FY2013 than in FY2012.  The decline in examinations occurred across all tax return types, including individual, corporation, S corporation, and partnership. In particular:

  • Individual Income Tax Return Examinations – The number of individual income tax return examinations decreased for the third straight year.  The IRS examined 1,404,931 (one of every 104) tax returns in FY2013.  This is approximately 11 percent fewer examinations than the 1,581,394 reported in FY2010 (one of every 90). During FY2013, 81 percent of the examinations of individuals were performed by correspondence.  One of every 541 individual income tax returns filed received a face-to-face examination, which is a 4 percent decrease compared with FY 2012, when one of every 522 individual returns received a face-to-face examination.
  • Corporate Income Tax Return Examinations – Fewer corporate tax returns were examined during FY2013 than any of the past five years.  The number of examinations decreased in FY2013 to a five-year low of 27,480 (one of every 70 returns filed). Also in FY2013, there were fewer corporate tax filings than in any of the last five years (1,912,105).  Over the past five years, the number of corporate tax returns examined with assets of less than $10 million decreased 4 percent, from 18,298 in FY2009 to 17,604 in FY2013.  These examinations decreased by 17 percent in the past year alone, from the five-year high in FY2012 of 21,164. As examinations of these returns have reached lows, filings have also dropped over the past five years.  Corporate tax return filings with assets of less than $10 million have decreased nearly 14 percent since FY2009, with a 2 percent decrease since FY2012.
  • S Corporation Tax Return Examinations – The number of S corporation examinations decreased 14 percent from the 21,658 examinations conducted in FY2012.  However, the number of S corporation examinations in FY2013 (18,670) was nearly 7 percent more than the number examined in FY2009 (17,455).  In FY2012, one of every 206 S corporation returns filed were examined, compared with one of every 240 filed in FY 2013. S corporation return filings increased for the fifth straight year, reaching 4.5 million in FY2013.
  • Partnership Return Examinations – The number of partnership returns examined decreased 11 percent to 14,870 in FY2013 after increasing to 16,691 in FY2012.  One of every 211 returns filed in FY2012 were examined.  This decreased to one of every 239 in FY2013. Partnership return filings increased to 3.6 million in FY2013.
  • Other Tax Type Examinations (fiduciary, employment, excise, estate, and gift taxes) – The overall number of examinations in these five classes was 87,836 for FY2013.  This is a 13 percent decrease in examinations from FY2012, when the number of examinations was more than 101,000.  Each of the five other tax type returns experienced decreases in the number of examinations between FY2012 and FY2013.  Excise return examinations decreased by 25 percent and estate return examinations decreased by 14 percent.  During FY2012, only one of the five other tax types (estate) experienced decreases in the number of examinations.  The return filings increased for all five of these other tax type returns in FY2013.  Estate return filings and excise return filings increased 123 percent and 52 percent, respectively.

Another important measure of audit productivity is the percentage of audited tax returns that result in recommended adjustments to the tax return.  The IRS associates a high percentage of audited tax returns that result in recommended adjustments with greater audit productivity, while audits that result in no change are considered unproductive.  The no-change rates for:

  • Revenue agent examinations of individual tax returns reached a five-year low in FY2011 (8 percent).  Since then, the no-change rate gradually increased to 10 percent in FY2013.
  • Tax compliance officer examinations of individual tax returns continued to remain at either 9 or 10 percent between FY2009 and FY2013.
  • Revenue agent examinations of corporate tax returns increased to 29 percent during FY2013.
  • Revenue agent examinations of partnership returns increased during FY 2013 to 47 percent.  The no-change rate increased in FY2010 (44 percent) and FY2011 (48 percent) and decreased in FY2012 to 44 percent.
  • Revenue agent examinations of S corporations continue to decrease from 39 percent in FY2011 to 33 percent in FY2012 and 31 percent in FY2013.

The conclusion to TIGTA’s report is as follows:

The IRS faced many challenges during FY 2013, including implementing provisions related to new tax legislation and operating with fewer resources and employees.  Several indicators showed the negative effect of these challenges, including a continued increase in accounts receivable, an increase in the number of cases that might never be worked, and a decrease in the overall number of examinations of tax returns.  While some indicators are positive, including increases in gross collections, enforcement revenue, and dollar yield per hour on examinations of corporations, the negative trends continue to be cause for concern, especially given that diminished enforcement could also affect voluntary compliance over time.

IRS Releases Annual Data Book of Agency Activities

Today the Internal Revenue Service released its annual data book, which it describes as a “snapshot of agency activities for the fiscal year.”  The time period covered in the FY2013 Data Book is October 1, 2012, through September 30, 2013.  We will be analyzing the data book and reporting on its substance over the coming days.  In the meantime, here is the press release announcing release of the FY2013 Data Book:

WASHINGTON — The Internal Revenue Service today released the 2013 IRS Data Book, a snapshot of agency activities for the fiscal year.

The report describes activities conducted by the IRS from Oct. 1, 2012, to Sept. 30, 2013, and includes information about returns filed, taxes collected, enforcement, taxpayer assistance and the IRS budget and workforce, among others.

During fiscal year 2013, the IRS collected almost $2.9 trillion in federal revenue and processed 240 million returns, of which 151 million were filed electronically. Out of the 146 million individual income tax returns filed, almost 83 percent were e-filed. More than 118 million individual income tax return filers received a tax refund, which totaled almost $312.8 billion. On average, the IRS spent 41 cents to collect $100 in tax revenue during the fiscal year, matching low-cost results for 2008 and 2001.

The IRS examined just under one percent of all tax returns filed and about one percent of all individual income tax returns during fiscal year 2013.  Of the 1.4 million individual tax returns examined, over 39,000 resulted in additional refunds. The IRS provided taxpayer assistance through 456 million visits to IRS.gov and assisted almost 91 million taxpayers through its toll-free telephone helpline or at walk-in sites.

Our analysis of the FY2012 Data Book is available here.

IRS Extends Effective Date of LB&I IDR Enforcement Procedures to March 3

We previously posted about the new Information Document Request (IDR) enforcement procedures announced last fall by the IRS Large Business and International Division (see prior post here).  The effective date of those procedures was supposed to have been January 2, 2014.  On February 7, however, the IRS announced that the effective date of the new IDR procedures was being extended to March 3, 2014.  In its announcement, the IRS stated that the extension was needed in order to “provide the clarification that is necessary to ensure that the procedures governing IDR issuance and enforcement are easily and clearly understood.”

Latest IRS Statistics Show Decline in Audit Rates, Uptick in Criminal Investigations

The Internal Revenue Service has released its FY 2013 “Enforcement and Service Results” (available here), which provide statistics as to the agency’s audit, collection, and enforcement activities.  FY 2103 began on Oct. 1, 2012, and ended on Sept. 30, 2013.  A number of interesting conclusions can be drawn from the data.

Audit Activity

The audit rate for individual tax returns in FY2013 was .96 percent, the lowest such rate since FY2006.  The total number of audits during FY2013 was 1.4 million, with over 1 million of that number consisting of correspondence audits.

The audit rate based upon amount of income also decreased in 2013 in all categories reported by the IRS.  For taxpayers with income of under $200,000, the FY2013 audit rate was .88 percent (as comparied to 1.04 percent in FY2010, 1.02 percent in FY2011, and .94 percent in FY2012).  For taxpayers with income between $200,000 and $1 million, the audit rate dropped to 3.26 percent (as compared to 3.93 percent in FY2011 and 3.70 percent in FY2012).  For taxpayers with income in excess of $1 million, the audit rate in FY2013 again decreased, to 10.85 percent (as compared to 12.48 percent in FY2011 and 12.14 percent in FY2012). 

For businesses, the audit rate also declined.  For all entity returns, the FY2013 audit rate was .61 percent (as compared to .63 percent in FY2011 and .71 percent in FY2012).  Audit rates also dropped in each category of business returns, as shown below:

  • Small corp returns (assets under $10 million):  .95 percent (FY2012 1.12 percent)
  • Large corp returns (assets over $10 million):  15.84 percent (FY2012 17.78 percent)
  • S corp returns:  .42 percent (FY2012 .48 percent)
  • Partnership returns:  .42 percent (FY2012 .47 percent)

Enforcement Results

The IRS collected over $53 billion in “enforcement revenue” in FY 2013, which includes taxes, interest, and penalties.  This was an increase over FY2012 ($50 billion) but a decrease as compared to FY2011 ($55 billion) and FY2010 ($57 billion).  A likely explanation for this decline in enforcement revenue is steadily decreasing levels of IRS enforcement personnel (revenue officers, revenue agents, and special agents).  In FY2013, the IRS had a total of 19,531 enforcement personnel, the lowest number in a decade.  Enforcement positions at the IRS have been diminishing as a result of budget cuts, retirements, attrition, and the like, as the following figures demonstrate:

  • FY2010 enforcement personnel:  22,710
  • FY2011 enforcement personnel:  22,184
  • FY2012 enforcement personnel:  20,868

In FY2013, the IRS undertook fewer collection activities as well, again likely due to staffing reductions, as the following figures demonstrate:

  • Levies:  1.8 million (compared to 2.9 million in FY2012)
  • Liens:  602,005 (compared to 707,768 in FY2012)
  • Seizures:  547 (compared to 733 in FY2012)

On the criminal investigation side, the statistics generally show an uptick in activity by the IRS.  In FY2103, there was a spike in the number of criminal prosecutions recommended, to 4,364, as compared to 3,701 in FY2012.  The overall conviction rate for tax and tax-related cases remained generally flat, at 93.1 percent.  The average jail sentence for tax and tax-related case also remained flat, at 31 months.  Finally, the total number of criminal investigations initiated in FY2013 increased to 5,314 (as compared to 5,125 in FY2012) and the total number of taxpayers who were criminally charged in FY2013 also increased, to 3,865 (as compared to 3,390 in FY2012).

TIGTA Again Critical of IRS Correspondence Audit Process

The Treasury Department’s Inspector General for Tax Administration (TIGTA) has issued another audit report critical of the IRS correspondence audit process.  (See prior post here.)  In its latest audit report, entitled “Actions Are Needed to Strengthen the National Quality Review System for Correspondence Audits,” TIGTA found that problems with correspondence audits are not always recognized and reported, resulting in missed opportunities for the IRS to reduce noncompliance that contributes to the Tax Gap and promote tax system fairness among taxpayers. 

In contrast to the more detailed and lengthy face-to-face audit at an IRS office or in the field at a taxpayer’s place of business, the correspondence audit process is conducted by mail and is less intrusive, more automated, and conducted by examiners who are trained to deal with less complex tax issues.  Because of its automated features and less complex tax issues, the correspondence audit process enables the IRS to reach more taxpayers at a lower cost.  The IRS currently conducts correspondence audits in approximately 37 program areas.

By FY2008 and FY2012, the IRS conducted almost 5.7 million correspondence audits and recommended approximately $40.4 billion in additional taxes.  This represents about 77 percent of all audits the IRS conducted of individual income tax returns and about 56 percent of the estimated $72.4 billion in recommended additional taxes resulting from those audits.  The responsibility for conducting correspondence audits rests largely with the IRS’s Small Business/Self-Employed (SB/SE) Division, which handles complex individual tax returns, and its Wage and Investment Division, which handles simple tax returns filed by individuals reporting wages, interest, dividends, and other investment income.

The correspondence audit process typically begins with the IRS mailing a computer-generated letter from one of its campuses to a taxpayer. The letter outlines the examination process, identifies one or more items on the tax return being questioned, and requests supporting information to resolve the questionable items. Once the requested information is returned, examiners review it to determine whether it resolves the questions.  If the questions can be sufficiently answered by the information provided, the audit is generally closed without any changes to the tax; if not, the taxpayer is sent a letter requesting more information or indicating a recommended change to the tax.  The taxpayer can thereafter:

  • Agree with the examiner;
  • Provide the examiner with clarifying information; or
  • Appeal the decision to the IRS’s Office of Appeals.

In instances where the taxpayer does not respond to IRS letters, the examiner’s recommended tax changes are assessed by default and the taxpayer will generally have to file a petition in the U.S. Tax Court to contest the assessment.

To ensure that correspondence audits are conducted in a quality manner, the IRS uses a comprehensive quality review system.  The system includes a statistical sampling of correspondence audits.  The IRS has established seven auditing quality standards.  Each standard has key elements that elaborate on and further define the overall standard.  For example, one of the key elements for Adequate Consideration of Significant Issues instructs examiners to consider and/or pursue audits of the prior and/or subsequent year returns when they contain the same issues as in the year examined.  (A recent TIGTA audit report criticized the IRS for failing to pursue correspondence audits of prior and/or subsequent years.)  Another quality standard examines whether applicable penalties were considered and applied correctly.

The quality review system is conducted at the management level, where “first line managers” review the documentation for a sample of audit case files to identify and correct quality problems in conjunction with evaluating the performance of the examiners they supervise.  In addition, each of the five IRS campus sites that conduct correspondence audits also perform quality review audits as part of the IRS-wide National Quality Review System (NQRS).

TIGTA’s audit discovered that the National Quality Review System should be strengthened because numerous errors were found during the audit process.  TIGTA found numerous errors in tests of the accuracy-related penalty determination category that were not detected and reported by NQRS quality reviewers.  For example, TIGTA found that in cases where examiners disallowed itemized deductions in excess of $20,000 due to lack of documentation, no negligence penalty was asserted.  Similarly, TIGTA found that in cases were taxpayers understated their tax liabilities, penalties were not considered.  TIGTA also found “inconsistency and confusion” over when, and if, the scope of single-year audit should be expanded to include prior and/or subsequent years. 

In management’s response to the TIGTA audit, IRS largely agreed with the findings and recommendations.  As a result, we expect to see a greater focus from examiners and their managers on the assertion of penalties, where appropriate, during the correspondence audit process.  We also expect to see more prior and/or subsequent year audits in this area.

TIGTA Audit Report: Budget Cuts Devastate IRS Enforcement Activities

The Treasury Department’s Inspector General for Tax Administration (TIGTA) has issued a report entitled “Trends in Compliance Activities Through Fiscal Year 2012” which confirms that cuts to the Internal Revenue Service budget have taken a severe toll on the agency’s ability to carry out its enforcement mission.  The report studies the IRS’s collection and examination functions during FY2011 and FY2012.

The report opens by noting that while the “Tax Gap” — the difference between what is owed in taxes each year and what is paid voluntarily — is steadily growing, both the IRS’s budget and enforcement revenue are decreasing.  (In a separate audit report, TIGTA has criticized the IRS calculation of the Tax Gap as well.  That report is available here.)  For tax year 2001, the IRS estimated the Tax Gap at $345 billion.  For tax year 2006 (the most recent estimate available), the IRS estimates the Tax Gap to be $450 billion, an increase of 30 percent.  Meanwhile, the IRS budget has decreased from FY2010 to FY2012, with a further reduction of $600 million in FY2013 due to the sequester.  These budget cuts have caused a reduction of approximately 8,000 full-time IRS positions since FY2010, including 5,000 from what TIGTA describes as “front-line enforcement personnel.”  In addition, the report notes that over 30 percent of executives, and 20 percent of non-executive managers, are currently eligible for retirement. 

The audit report notes that enforcement revenue has declined for two straight years, and is currently 13 percent less than the FY2010 level.  TIGTA concluded that this decline correlates directly with the 14 percent reduction in the number of IRS enforcement personnel.  At the same time, the number of tax returns being filed has steadily increased.

On the collection front, the TIGTA report notes that revenue collection decreased by 7 percent from FY2011 to FY2012.  In addition, the overall use of key collection mechanisms — liens, levies,and seizures — has decreased.  Between FY2011 and FY2012, the use of tax liens dropped a whopping 32 percent, but that decline is likely attributable to the new Fresh Start Initiative which limited the IRS’s ability to impose liens in certain circumstances in order to help individuals and small businesses meet their tax obligations without adding unnecessary burdens. 

On the audit front, the IRS has experienced a 13 percent reduction in the number of personnel who conduct examinations of tax returns.  In FY2012, the IRS conducted 4 percent fewer audits, and 70 percent of those examinations were conducted by correspondence.  In FY2012, the number of individual tax returns that were examined decreased for the second straight year, while the number of corporate tax returns that were selected for audit increased to a five-year high.  Gift tax examinations have increased every years since FY2009, and have nearly tripled since FY2008. 

The TIGTA report concludes as follows:

The IRS faced many challenges during Fiscal Years 2011 and 2012, including implementing provisions related to new tax legislation and operating with fewer resources and employees.  Several indicators showed the effect of these challenges, including a decrease in enforcement revenue, a continued increase in accounts receivable, an increase in the number of cases that might never be worked, and a decrease in the overall number of examinations.  Nevertheless, many indicators increased, including gross collections and the examinations of certain tax returns.  Some of these trends are cause for concern, especially given that diminished enforcement could also affect voluntary compliance over time.

IRS Releases Key Statistics on Audit Rates and Enforcement Activity

The Internal Revenue Service has released its annual data book, which it describes as a “snapshot of agency activities for the fiscal year.”  The time period covered in the FY 2012 Data Book is October 1, 2011, through September 30, 2012. 

Among the data presented in the FY 2012 Data Book are audit rates for the past year.  The overall audit rate for individual tax returns was 1.03 percent, which is generally consistent with prior years.  The audit rates for wealth taxpayers, however, saw a slight decrease.  The following chart nonetheless illustrates that the audit risk dramatically increases for taxpayers reporting large amounts of adjusted gross income:

IRS Audit Rates FY 2010 FY 2011 FY 2012
All returns 1.11% 1.11% 1.03%
No AGI 3.19% 3.42% 2.67%
AGI $1 to $25,000 1.18% 1.22% 1.05%
AGI $200,000 to $500,000 1.92% 2.66% 1.96%
AGI $500,000 to $1 million 3.37% 5.38% 3.57%
AGI $1 million to $5 million 6.67% 11.80% 8.90%
AGI $5 million to $10 million 11.55% 20.75% 17.94%
AGI over $10 million 18.38% 29.93% 27.37%

The overall audit rate for estate tax returns is nearly 30 percent, with 12,582 estate tax returns filed during calendar year 2011.  The audit rate for estate tax returns where the size of the gross estate is between $5 million and $10 million is 58.6 percent.

On the enforcement front, the IRS assessed nearly $26.9 billion in civil penalties during FY 2012, and initiated 5,125 new criminal tax investigations.  2,466 taxpayers were convicted of a tax crime during FY 2012, and 2,009 of those individuals (or 81.5 percent) received a sentence of incarceration.  The number of IRS Special Agents (who are responsible for conducting criminal investigations) employed by the agency is down, from 2,730 in FY 2011 to 2,657 in FY 2012.

On the international enforcement front, Acting Commissioner Steven T. Miller offers the following assessment:

The IRS in 2012 made significant progress on international enforcement, specifically in our efforts against the practice of illegally hiding assets and income in offshore accounts.  We have continued our two-pronged approach: offering a voluntary disclosure program for those who want to come in and get right with the government, while at the same time pursuing tax evaders and the promoters and banks assisting them.

Although not discussed in the FY 2012 Data Book, the IRS Offshore Voluntary Disclosure Program remains open and provides a mechanism for taxpayers with undisclosed foreign bank accounts and unreported income from such accounts to obtain amnesty from criminal prosecution through the payment of back taxes, interest, and penalties.  To date, more than 35,000 individuals have enrolled in the OVDP since 2009 and more than $5 billion in additional revenue for the U.S. Treasury has been generated.  Details on how to enroll in the OVDP are available here.