US budget deal to simplify partnership audits

Late Monday night, the White House and Congress reached a tentative two-year budget deal that is set to simplify the way US tax authorities audit large partnerships, including private equity firms and law firms.

At the inaugural pfm Tax Forum in Boston, delegates expressed concern that the budget deal would result in more frequent audits of large, complex partnerships and could also mean more time and resources spent educating auditors on the nuances of the private funds model.

Auditors with little experience reviewing large partnership structures are bound to make mistakes or ask irrelevant questions, one delegate cautioned at the forum. The delegate said that an auditor from the Internal Revenue Service (IRS), who only had a background in reviewing corporate structures, once erroneously attempted to designate management fees as a dividend paid by a portfolio company.

“We had a situation where a portfolio company was being audited, and the auditor was asking for a copy of the cheque we used to purchase the investment,” another delegate shared. “She didn’t understand that millions of dollars are moved through wires.”

A third delegate at the forum said that the IRS was looking to recruit auditors with more experience structuring, reviewing and auditing complex partnership entities.

If passed into law, the budget deal would simplify the three different methods currently used to audit large partnerships by revamping rules under the Tax Equity and Fiscal Responsibility Act of 1982.

Under the streamlined audit approach, the IRS would examine the partnership’s items of income, gain, loss, deduction, credit and partners’ distributive shares for a particular year of the partnership. Any adjustments would be taken into account by the partnership (not the individual partners) in the year that the audit is completed, a summary of the bill said. Small partnerships with fewer than 100 partnerships are eligible to opt out of the new regime, which takes effect in 2018.

A study conducted last year by the Government Accountability Office (GAO) found that a mere 0.8 percent of large partnerships – defined as having 100 or more direct and indirect partners and $100 million or more in assets – underwent audits in fiscal year 2012, compared to 27.1 percent of large corporations.

During the GAO investigation, IRS officials reported having difficulty tracing income from its source through the many tiers at a top partnership entity. Under these tiered arrangements, the amount of partners can run into hundreds of thousands, the report said. The IRS also said current tax law provides them with limited legal authority to effectively conduct audits in a timely manner.

This article originally appeared in Private Funds Management.