Increase in IRS Partnership Audits

[kcjenkins]

The current IRS goal is to increase audits of partnership tax returns with an emphasis on administrative matters in addition to the usual compliance issues. The IRS's initiative is to provide advanced partnership examination training to their revenue agents (aka “auditors”). Partnerships that are following their operating agreements and complying with applicable filing requirements will have less to fear than those who have been careless on the details.

Knowing that the IRS will be coming to the table with a competitive edge, you should arm yourself with as much knowledge as possible. Two resources I recommend for partnership audit preparation:

IRS Partnership Audit Technique Guide – this is the IRS manual for their auditors to use when auditing partnerships; very helpful to review prior to representing a client in an audit.

IRS.gov page on audits of small businesses – an overview of rights, required records and FAQs.

If you have other resources or tips about audit preparation, please share!

[Guest Taxed]

I recall seeing a post about this matter previously. It was just a matter of time before IRS focused on pass through entities.

The Audit Technique Guides are very helpful to know what the agent may zoom in, upon audit and be prepared.

[SaraEA]

A couple of years ago when I was taking courses for my Masters in Taxation, 6-9 of my classmates were IRS agents or employees (varied by class). When we took the much-dreaded partnership course, they shared the fact that the IRS really wanted to audit more partnerships but did not have the expertise to do so. I don't have to tell anyone on this board that partnerships are complicated (especially when they buy in with property or services instead of cash, or when someone inherits a partnership interest). IRS employee training is excellent, but does anyone here really think they've been able to train enough people to audit these groups? In recent years many of us have found ourselves mentoring "green" auditors on reasonably straightforward 1040 and Sch C returns. There are not enough hours in the day to teach them about partnerships! I suspect their thrust will be toward S corps, maybe estates and trusts (all of which have well-known opportunities to cheat). Partnerships, where in my experience a lot of cheating occurs, will remain out of their league.

[jshtax]

I would be willing to say 0-10% of partnerships I deal with have an operating agreement they follow. Most make money and go about their business. Not sure what could be in the OA that would impact an audit.

[kcjenkins]

From the Audit Guide:

Partner’s Interest in the Partnership Test

Partnership Agreement

A partner’s distributive share of income, gain, loss, deduction, or credit is generally determined by the partnership agreement. The term “partnership agreement” is very broad and refers to any agreement which has an impact on the economic sharing arrangement among the partners or between one or more partners and the partnership. Treas. Reg. section 1.704-1(b (2)(ii)(h). The partnership agreement may be oral or written. Any document or oral agreement which bears on the underlying economic arrangement of the partners, is considered to be part of the partnership agreement. Examples of such documents may be:

• Loan and credit agreements;
• Assumption agreements;
• Indemnification agreements;
• Subordination agreements;
• Correspondence with a lender concerning terms of a loan;
• Guarantees.

Emphasis: The partnership agreement encompasses more than just the partnership agreement document.

Determining the Partner’s Interest in the Partnership

The partner’s interest in the partnership test is a subjective facts and circumstances test. It seeks to determine the true economic sharing arrangement of the partners based on all of the facts and circumstances (Treas. Reg. section 1.704-1(b (3)). The regulations consider the following factors to be relevant but not exclusive:

a) the partners’ relative contributions to the partnership

b ) the interests of the partners in economic profits and losses

c) the interests of the partners in cash flow and other non-liquidating distributions

d) the rights of the partners to distributions of capital upon liquidation

There is an important interconnection between the partners’ interest in the partnership test and the substantial economic effect test. The two tests can be viewed as two different roads leading to the same destination. Both seek to ensure that tax allocations parallel the partners’ economic sharing arrangement. Allocations will be respected under either set of rules. The economic effect test is a mechanical test governed by lengthy and detailed regulations. In contrast, the regulations covering the partners’ interests in the partnership test are short, simple, and subjective.

The essence of both tests is to tie the tax allocations to the partners’ economic sharing arrangement.

[jshtax]

The partnership agreement may be oral or written.

So you can make it up on the fly to suit the auditors needs.

[kcjenkins]

Not really, because the ACTIONS TAKEN have to match the agreement. If I took on a partnership that did not have a written agreement, what I always asked them to do was to sit down with me and have them write down what their agreement is. I'd ask them about who put in what, etc.

Now, if it's a new client coming to me because the partnership is being audited, and they don't have a written OA, I'd do the same thing. THEN I'd review the past three years at least, to see how well their allocations of income and expense matched what they said. By the time of the audit, we'd have a written version of the original oral agreement.

[jshtax]

Lets say they do not have one and everything has been split 100-0 for profit and loss what could the IRS do?

[Guest Taxed]

In practical terms, most states/cities require partnerships to register to get a business license. So the details of the partners are in written form somewhere. It is not smart to have an oral partnership fr obvious reasons.

[kcjenkins]

Lets say they do not have one and everything has been split 100-0 for profit and loss what could the IRS do?

Then the IRS is going to question why the partnership at all, and they are going to look at what each put into the business. They will not allow one to take all the profits and/or losses, if in reality it is a partnership. They might try to divide them between the partners in another ratio. The Audit Guide will give you examples.