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July 23, 2012
Audit Proof? How Hedge Funds, PE Funds, and PTPs Escape the IRS

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by Amy S. Elliott


True or false: The largest U.S. businesses are under continuous audit by the IRS.

False. Some are effectively immune from audit. Whether a business is audited every year depends in part on its form of organization.

While the tax planning strategies and low effective rates of household-name, publicly traded corporations have made newspaper headlines, those companies are regularly and thoroughly examined by the IRS.

But large, widely held partnerships, including publicly traded partnerships (PTPs) -- which generally have thousands of direct and indirect partners -- seem largely to escape the scrutiny that the Service gives to their C corporation counterparts.

PTPs (such as oil and gas and real estate funds and investment funds like the Blackstone Group LP, the Carlyle Group LP, and KKR & Co. LP) aren't the only lucky ones. While private hedge, private equity, and venture capital funds might not be widely held in terms of the number of direct partners, if one of their investors is a fund of funds, the number of indirect partners balloons.

Through an investigation based on interviews with dozens of practitioners who have direct knowledge of the IRS's large partnership audit practices, including many with government experience, Tax Analysts has learned that this growing class of business entities poses serious problems for tax examiners.

Hampered by the 1982 Tax Equity and Fiscal Responsibility Act, the law governing large partnership audits, and its aging information technology systems, the IRS lacks the capacity to audit more than a few large, widely held partnerships each year.

That capacity constraint -- a numerical figure known to only a select few at the IRS -- concerns the number of partner-level tax bills that the IRS can send out each year. Because partnerships are passthrough entities, IRS agents can't determine the resulting net tax revenue from any partnership-level adjustments until they've calculated their impact on a partner-by-partner basis (as some partners may be tax-exempt foreigners, pension funds, or taxpayers with net losses). If the IRS doesn't audit the partnership itself, it generally can't challenge the partnership profits and losses reported on an individual partner's return.

The problem is severe enough that the Obama administration has proposed treating some very large partnerships as corporations for audit purposes.

Nearly all interviewees spoke on condition of anonymity. All facts reported in this article were verified by multiple independent sources.

CIC or Not CIC

The IRS takes a thorough approach to its audits of many large C corporations. Under the coordinated industry case (CIC) program, more than 800 major U.S. corporations are audited year after year by a skilled team of IRS agents who maintain offices at the taxpayer's headquarters. The continuous focus helps those agents identify and develop expertise in a given corporation's tax issues over time.

The program has proven successful. CIC audits reportedly take up only about 20 percent of the IRS's examination resources but result in about two-thirds of the proposed dollar adjustments. Businesses not classified as CICs generally get fewer agents, resources, and time -- if they're audited at all.

Widely held partnerships are theoretically eligible for CIC treatment, but few, if any, are being audited under the program, according to informed sources. Instead, nearly all of the income and loss from investment fund PTPs that is being reported on the tax returns of fund managers and wealthy investors is unchallenged by the IRS. The IRS responded that while the CIC program isn't tailored to partnerships, "we always ensure that the appropriate level of expertise is involved in all of our partnership examinations."

On March 26 Steven Miller, IRS deputy commissioner for services and enforcement, announced plans to streamline CIC audits and focus some of the resource savings on passthroughs. But he emphasized that the Service's visible exam presence among large corporate taxpayers will remain.

"We must maintain coverage in sectors where there is significant economic activity and revenue-producing assets," Miller said, speaking of the corporate sector in particular.

IRS Statistics of Income division data show that more businesses are organizing as partnerships and that more of those partnerships rival the size of corporations on which the IRS Large Business and International Division has historically focused its audit resources. According to SOI estimates, in 2009 there were more than 18,000 partnerships -- compared with more than 23,000 corporations -- with at least $100 million in balance sheet assets.

In recent years, the number of large, publicly traded partnerships, some with very complex financial activities and multitiered structures, has also grown. Investment firms have taken advantage of the PTP rules to gain access to retail investors while avoiding corporate-level tax on the bulk of their income. These firms actually consist of hundreds, possibly thousands, of legal entities, which all may be effectively exempt from audit because of the IRS's capacity limitation.

A June 14, 2007, release from Senate Finance Committee Chair Max Baucus, D-Mont., and then-ranking minority member Chuck Grassley, R-Iowa, drew attention to what it called the "troubling trend" of investment fund partnerships (such as Blackstone and KKR) becoming publicly traded by falling under the qualifying income exception in section 7704(c). That trend "causes deep concern about preservation of the corporate tax base," the lawmakers wrote.

The growth in investment fund partnerships raises questions about how well the IRS will continue to audit large businesses if more of them move away from corporate structures and adopt partnership models. The Service has long audited partnerships at a much lower rate than it does corporations. In fiscal 2011 the IRS audited 13,770 partnership returns. That was more than twice as many as were audited 10 years earlier, but it still represented only 0.4 percent of the total partnership returns filed the previous year; the comparable rate for corporations (excepting subchapter S entities) was 1.5 percent.

The IRS does not release statistics on its audit coverage of widely held partnerships, and it declined to provide data to Tax Analysts. But a 2006 Treasury Inspector General for Tax Administration report that included data on partnership audits by asset class hints at the severity of the problem. In 2005 the largest partnerships (those with assets of at least $250 million) were nearly five times less likely than their corporate counterparts to be audited by the IRS. The category does not perfectly correlate with widely held partnerships, because some high-asset entities have only a few partners, but most partnerships with thousands of partners fall on the higher end of the asset scale.

Nearly 30 percent of audits of the largest partnerships were closed without any change to the partnership return (although there could have been changes to partner returns), TIGTA said. The remaining audits resulted in an average adjustment of about $2.8 million, which works out to -- at most -- an average additional tax due of $980,000 per return, assuming a 35 percent tax rate.

By comparison, more frequent and larger adjustments were made to the returns of comparably sized corporations that same year, according to the 2005 IRS Data Book. In auditing corporations with assets of at least $250 million, the IRS made no changes to about 8 percent of the returns, while the remaining audits resulted in an average recommended additional tax due of $6.7 million per return.

On July 19 TIGTA released a report containing data on partnership audits worked by IRS Small Business/Self-Employed Division examiners. While the number of audits of partnerships with less than $10 million in reported assets has steadily increased from 2007 through 2011, the report found that SB/SE made no changes to about 36 percent of its partnership audits.

Terrible TEFRA

While IRS audit coverage of large partnerships has historically been poor, widely held partnerships present their own special hurdles. Ironically, many of those hurdles have grown out of TEFRA, Congress's attempt to make large partnership audits easier and more evenhanded for the IRS and taxpayers.

Before 1982, while the IRS could audit a partnership at the entity level, each partner could separately contest partnership adjustments of income, gain, loss, deduction, credit, etc. Different practices in the field created disparate outcomes for similarly situated partners.

In response, Congress passed TEFRA, which enabled the Service in most cases to challenge partnership items in a single proceeding at the entity level.

But while the new process is more streamlined in some ways, partner safeguards and notification requirements make it burdensome when thousands of partners are involved. Under TEFRA, partners must be notified of an audit (section 6223) and retain the right to participate in the audit (section 6224). After sending notice of the end of the audit, the IRS then issues partner-level assessments (the notice of computational adjustment) for deficiencies attributable to partnership items (section 6225).

Those seemingly straightforward requirements have severely hampered IRS partnership audits. At the beginning of an audit, the IRS must send a notice of beginning of administrative proceeding (NBAP) to the partnership's tax matters partner (section 6223(b)(2)). But copies must also be sent to all partners with a profits interest of at least 1 percent who were partners in the tax year under audit (notice partners under section 6223(a)).

The growth of widely held multitiered structures has made the partner notice and assessment process particularly daunting. A partner in a PTP may have held its partnership interest for only a few hours. And if a partner is itself a partnership, the IRS must look through it to find the ultimate beneficiary. If the IRS fails to provide proper notice, any assessments it makes may be invalid.

This problem isn't new. Twenty-two years ago, the IRS and Treasury told Congress that the "unwieldy" TEFRA procedures made it difficult to challenge positions taken by widely held partnerships and may be causing "significant loss of revenue to the government." At the time, there were about 1,200 partnerships with at least 1,000 partners. Although current figures aren't available, most analysts believe that number has grown geometrically.

Information Overload

The TEFRA notice procedures seem administrable. After all, the IRS sends out millions of taxpayer notices and letters each year. The problem is that the IRS service centers apparently can generate only a limited number of TEFRA partner-level assessments per year. The limitation lies in the stage of "linking" a partner to a partnership case (so that the partner's return can be obtained and controlled and the TEFRA partner-level notices can be generated).

IRM section 8.19.9.4 says that the Service's partnership control system database, which generates TEFRA notices, "allows an unlimited number of investors to be linked to each key case or tier and allows an investor to be linked to an unlimited number of pass-through entities." Unfortunately, the agency has yet to fully automate the linkage process, which requires a manual step to establish those partner/investor linkages.

The result is that the IRS cannot comply with the partner-level notice and assessment requirements for more than a few widely held, multitiered partnerships each year. Although the actual ceiling of the IRS's linkage capacity is uncertain, estimates suggest that had the IRS generated assessments for all the direct and indirect partners of the two largest PTPs last year, that alone would have maxed out its annual limit, leaving it unable to send notices to partners of any other TEFRA partnerships.

The IRS declined to comment on how many linkages can be established each year but said "It's inaccurate to say that our partnership decisions are limited by information technology resources. We don't make enforcement decisions strictly based on IT resources."

Looking for Easy Outs

IRS examiners who pursue TEFRA cases must overcome all those obstacles and do it within the three-year statute of limitations. Only then can the Service compute the resulting tax effect on each individual partner by looking at each partner's tax return for the year under exam. With such a cumbersome process leading to uncertain results, it's little surprise that IRS agents are often reluctant to start the audits in the first place.

Jerry Curnutt, a former national partnership industry specialist at the IRS who retired from the agency in 2000 and was involved in selecting partnership returns for audit, said that convincing a manager to audit a widely held partnership was extremely difficult.

"It's almost beyond my comprehension that a manager would allow an agent to open a case that had 1,000 partners," said Curnutt, who received four distinguished performance awards and an assistant commissioner's award during his last five years with the IRS. "If you're going to have 1,000 partners and all that that involves, you better have an issue that's a billion-dollar adjustment -- something that's going to be large -- because of the expenditure of time."

Widely held partnerships find the TEFRA rules similarly demanding. No partnership wants its investors receiving notices that it's under audit and bills for taxes due. Under TEFRA, however, that painful process can seem endless. The tax matters partner must provide the IRS with the name, address, profits interest, and identification number of every individual or entity that was a partner at any time during the year at issue and must send a copy of the NBAP to all non-notice partners (sections 6230(e) and 6223(g)). If the partnership is itself a partner in an upper-tier partnership under audit, it must pass along any notices it receives in connection with that exam to its partners (section 6223(h)).

The shared aversion to TEFRA has led the IRS and partnerships to try to sidestep the law's burdensome notice procedures as much as possible. Aiding them are provisions in the regulations that offer easy outs.

First, if the NBAP is withdrawn with no adjustments within 45 days of its issuance to the tax matters partner, neither the IRS nor the tax matters partner is required to notify the other partners (reg. section 301.6223(a)-2(a)). The IRS still gets internal credit for an audit, and the investors never have to know about the exam. It isn't clear exactly how an agent must substantiate the decision to propose no adjustments.

Second, if a partnership has few notice partners, a closing agreement may enable it to settle for a fraction of the full imputed underpayment without securing the agreement of non-notice partners while the IRS avoids having to process partner-level notices (reg. section 301.7121-1).

A partnership with 30,000 partners has many partners who don't meet the 1 percent profits interest threshold. That generally means that unless a non-notice partner (or an indirect partner not previously identified to the IRS) told the IRS otherwise in writing, the tax matters partner can agree to all proposed adjustments on that partner's behalf.

Those agreements may allow a partnership to pay some amount at the partnership level, effectively shifting the tax liability from those who were partners in the year under audit (and who benefited from the improper tax position) to the current partners.

The IRS has even been known to enter into agreements with partnerships before a final determination is made. The notice of final partnership administrative adjustment generally signals the end of an audit. The partnership may agree to pay an amount at the partnership level before the FPAA, the statutory notice of partnership adjustments, is issued. Under that scenario, not even notice partners would need to be informed.

Practitioners managing the audits of small and midsize partnerships are seeing other signs of the IRS's TEFRA enforcement capacity constraints. Several reported that the IRS is allowing the statute of limitations to expire and is issuing notices stating that no adjustment will be made because of a materiality threshold.

Worth the Bother?

Beyond the capacity limitation, money -- or rather the perceived lack of it -- could be a reason for the scant number of widely held partnership audits. The IRS focuses its exam efforts on cases that provide the most bang for the buck, and many observers argue that there isn't enough money to be found in widely held partnerships to make such complex examinations cost-effective.

It's a common misunderstanding that auditing a partnership generally results only in a reallocation of income and loss between the partners, with no real net taxes to be collected.

But in fact an audit could result in significant adjustments to the income or loss reported by the partnership as a whole and would thereby have material effects on the distributive shares of all the partners.

Sources said that some of the issues that could result in adjustments in favor of the government include converting ordinary income to long-term capital gain, taking deductions for questionable items, aggressive use of fund fee waivers and deferrals, overleveraging of blockers, and improper partnership allocations.

Also, widely held partnerships should be audited for failure to withhold on effectively connected income or Foreign Investment in Real Property Tax Act of 1980 income (sections 1445 and 1446), improper use of securities aggregation rules and stuffing allocations, and aggressive fund manager compensation plans (sections 457A and 409A) and grants of profits interests.

Fix It Already

The problems posed by widely held partnership audits haven't escaped officials' notice. Spurred in part by suggestions from the IRS, President Obama's fiscal 2013 budget proposed a "required large partnership" (RLP) regime that would, for audit purposes, treat some very large partnerships as corporations.

The RLP proposal was an effort by the administration to improve the electing large partnership (ELP) regime while essentially forcing some partnerships into it.

The problem with the existing ELP program is that few partnerships have elected to use it. In 2009 only 109 partnerships filed a Form 1065-B, "U.S. Return of Income for Electing Large Partnerships." (For "Partnership Returns, 2009" by Nina Shumofsky and Lauren Lee, see SOI Bulletin 31, Fall 2011, http://www.irs.gov/pub/irs-soi/11pafallbulpartret.pdf.)

One major reason for the ELP regime's unpopularity has been its firm March 15 filing deadline for Schedule K-1. Because investor information is maintained by brokers and is constantly changing, partnerships frequently send out a Schedule K-1 by March 15 but then correct it because of inaccuracies in the broker data. Partnerships that enter into the ELP program could expose themselves to penalties for failure to furnish correct payee statements (section 6722). The RLP regime would update the ELP guidelines to allow the use of the normal April 15 filing deadline, with a possible extension to September 15.

While TEFRA requires the IRS to send tax bills to the partners who were partners in the tax year under audit, the RLP regime would give the IRS the authority to flow through any adjustments to the current partners. Or the partnership could elect to pay any deficiency itself. The RLP regime also shifts interest and penalty liability to the partnership.

On June 18 the Joint Committee on Taxation issued its analysis of the RLP proposal, stating that the costs of processing and mailing thousands of letters to each partner of a large partnership make the collection of deficiencies far less cost-effective.

"Though the number of direct and indirect partners in some partnerships is many tens of thousands under current business practice, the tax law has not kept up and does not currently require reporting of their identities or even the number of them," the JCT wrote.

"Partners in a partnership with over 1,000 partners start to resemble shareholders of a widely-held corporation in some respects. Their relationship with each other and with the partnership may become more attenuated when they are so numerous. In this situation, centralized audit and resolution of partnership items may be more appropriate," the JCT said.

Asked for comment on the questions raised by this article, an IRS spokesman said, "We continue to ensure that an appropriate level of resources are dedicated to partnerships." He added that the Service is aware of the growth in partnerships and is continuing to develop its expertise and tools to more efficiently examine them. "We continue to look at expanding our partnership coverage as well as looking at legislative proposals to help our efforts in this area," he said.

Can't Touch This

Jennifer Alexander, attorney-adviser (partnerships) in Treasury's Office of Tax Legislative Counsel and the point person for the proposal, told Tax Analysts that in the five months since the RLP proposal's release, she has received no questions or comments on it from outside stakeholders.

Congress, meanwhile, may have little desire to enact legislation that could increase the tax bills of investment fund managers and investors, who are important campaign contributors for both parties in an election year. So it's likely that another year will go by with widely held partnerships believing they're audit proof.

The IRS's negligible enforcement presence among widely held partnerships does not encourage voluntary compliance. The easy-out strategies used with widely held partnerships may be backfiring. Far from instilling a sense of fear, those limited attempts at examining a fund's tax returns reinforce the widely held suspicion that agents have no comfort level with subchapter K issues.

On March 30, 2011, Terry F. Cuff of Loeb & Loeb LLP wrote on his own behalf to then-Treasury Assistant Secretary for Tax Policy Michael Mundaca, IRS Commissioner Douglas Shulman, and IRS Chief Counsel William J. Wilkins urging the IRS to step up enforcement of subchapter K for investment management partnerships.

Cuff scolded the IRS for its focus on examining the travel and entertainment expenses of large securities partnerships when it should be examining the aggressive tax positions on those same returns. Lax auditing practices make the IRS complicit in tax abuse, Cuff argued.

"Acquiescence by the Internal Revenue Service appears to be at least as much responsible for the general attitude of defiance as is the open defiance by the tax advisors," Cuff said. The IRS, he wrote, is "preoccupied with dripping faucets when the dam has broken."

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