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April 7, 2014
Audit Proof: The Other IRS Scandal

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[Editor's Note: "News Analysis: Why It Matters That the IRS Has Trouble Auditing Partnerships." Video:]

Have you ever wondered how the IRS decides who to audit?

Like most of us, you probably have.

Well, think of it this way: IRS auditors are like traffic cops. They monitor financial traffic and ticket those who don't follow the rules.

But instead of checking whether you're carrying a license or speeding, they check the income and deductions that you claimed on your return.

And instead of issuing you a ticket, they issue you a letter proposing adjustments to your return and a bill for additional taxes due.

In traffic and in tax, if the enforcers do their jobs correctly, everyone plays by the same rules.

But it turns out the IRS has trouble auditing some kinds of businesses, which lets certain business owners fly under the radar.

If you're one of 800 of America's largest corporations, the IRS is closely watching you.

Each one of those 800 businesses has a team of IRS agents in its headquarters, checking up on the company's tax positions day in and day out.

But if your business happens to be organized as a widely held partnership -- like many large private equity firms, oil and gas partnerships, and hedge funds -- an IRS audit is far less likely.

Here's how it works:

Business A sets itself up as a corporation.

Auditing a corporation is a lot like auditing you or me. The IRS looks at the income and deductions and decides if anything needs to be adjusted.

In the end, the corporation itself is responsible for paying the taxes. The IRS issues one tax bill.

Business B on the other hand sets itself up as a partnership. The IRS looks at its income and deductions, but if it identifies adjustments, it can't just apply them to one tax bill, because the partnership itself doesn't pay any tax. Its partners pay the tax on the partnership's income on their individual tax returns.

So the IRS has to parcel out the adjustments to each partner based on his individual interest in the partnership and then figure out the taxes due based on his individual tax situation.

But in widely held partnerships, there can be thousands of direct partners, many of whom might themselves be partnerships. And because ownership in some partnerships is traded just like shares of stock -- someone could be a partner for just a matter of minutes.

There are partnerships that have several hundred thousand ultimate partners. That's a lot of tax bills to issue.

Chances are the IRS won't bother with it. Even if it's one of the largest businesses in America.

These audit-proof partnerships essentially shield the partner's income and deductions from challenge by the IRS -- any partnership item claimed on the partner's individual return is essentially untouchable.

You're accountable to the IRS for your income. But the owners of some large businesses -- some of the wealthiest people in America -- effectively aren't.

For all the headlines the IRS has made recently, this could be the biggest.

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