IRS Plans to Go After ‘Complex Partnerships’ to Close Vulnerable Tax Gap

The Internal Revenue Service (IRS) building stands in Washington, D.C., on April 15, 2019. Zach Gibson/Getty Images

The Internal Revenue Service is planning to address what it calls “large, complex partnerships” in an attempt to go after business entities that avoid paying taxes by abusing a known loophole.

This would allow the agency to collect tens of billions of dollars in additional tax revenue, via introducing double audits for partnerships with $10 million or more in assets, by fiscal 2025 over fiscal 2021 levels.

New research published by the Government Accountability Office (GAO) found that the specific types of legal and commercial structures the IRS has been targeting needs to be better defined to recoup losses from uncollected funds.

The GAO posted a list of four major recommendations to help the IRS to improve how it selects partnerships to audit for boosting compliance.

Tax Partnership Loophole

Businesses have been increasingly organizing as partnerships to allow them to pass their income and losses onto their partners and to avoid being taxed as corporations, the GAO said in a report on July 27.

“IRS has not defined or developed guidance on what a large, complex partnership is or developed measures to ensure additional audits focus on such partnerships,” said the government’s internal watchdog.

This is one reason why large partnerships have surged in recent years as a commercial designation within the U.S. economy.

Businesses that register as partnerships do not pay taxes directly but pass their tax liability onto their owners through an IRS form K-1.

These companies can be hidden within other partnerships in networked or circular structures, making them very complex for auditors at the tax agency to sift through, which has led to declining audit rates.

“The lack of a definition presents a challenge as IRS seeks to increase its audit coverage of partnerships,” the report read.

Tax experts have long stated that partnerships were being abused as a potential tax dodge.

“The IRS does not treat K-1 income the same way that it does reports of people’s wages filed on W-2 forms or the reports of income from dividends, interest, royalties and contract jobs reported on Form 1099,” veteran tax reporter David Cay Johnston wrote in a 2003 book on the U.S. tax system, according to The Hill.

“IRS computers match every wage, dividend, interest, royalty and contract job report to what is listed on individual tax returns to make sure that every dollar earned in these ways is taxed. Not so partnership and K-1 reports.”

The IRS’s differential administrative treatment of partnership income is an example of what Treasury Secretary Janet Yellen has described as the United States’s “two-tiered tax system.”

“At the core of the problem is a discrepancy in the ways types of income are reported to the IRS: opaque income sources frequently avoid scrutiny while wages and federal benefits are typically subject to nearly full compliance,” she said in a 2021 statement on Congressional tax proposals.

Large Partnerships Increasingly Get Away With Tax Noncompliance

Over 80 percent of the IRS audits conducted on large partnerships failed to find any tax noncompliance on businesses registered as partnerships, said the GAO.

This suggests that the IRS did not choose the riskiest returns to audit or found it difficult to find noncompliance in audited businesses.

Around 84 percent of these entities reported providing finance and insurance services, or real estate and rental leasing.

“Large partnerships can be complex with income or business expenses passing through multiple levels such that a partnership could be a partner in another partnership,” said the report.

The number of large partnerships, with more than $100 million in assets and 100 or more partners, had increased sixfold, from 3,000 in 2002 to 20,052 in 2019.

The IRS audit rate for large partnerships has declined since 2007 to less than 0.5 percent, according to the GAO report.

It shockingly found that only 54 large partnerships out of the more than 20,000 registered were audited by the IRS in 2019—a rate of 0.27 percent, just below the audit rate for those who made $25,000 per year or less.

Meanwhile, the number of partnerships worth between $1 billion and $5 billion increased by over 1,000 percent during that same period, while the number of partnerships worth more than $5 billion increased more than 800 percent.

More than 80 percent of audits resulted in no change to the return on average from tax years 2010 to 2018, which was the rate of large corporate audits.

Those companies that did change saw their average adjustment at negative $264,000.

IRS Working to Plug Loophole

In a response to the GAO report, the IRS announced they were working on a plan to be more precise to define a large partnership to solve the problem.

“We plan to perform additional research and analysis to better understand the characteristics and define partnership segments,” Douglas O’Donnell, the IRS Deputy Commissioner for Services and Enforcement, wrote in a letter to the GAO earlier this month.

IRS Commissioner Danny Werfel told reporters earlier in July, that the public should expect more updates on how exactly the tax agency was going after these big partnerships shortly.

“We’re … focused on increasing our exam coverage for complex partnerships,” Mr. Werfel said. “In our upcoming next briefing, we’ll provide more details on that.”

IRS officials have also blamed the declining audit rate to lack of available resources.

The Inflation Reduction Act, which was passed last year, would have provided the IRS with $45.6 billion for enforcement activities through the end of fiscal year 2031.

The IRS planned to use the resources to pursue large partnerships as an enforcement priority.

About $1.4 billion of this funding was rescinded in 2023 after the Biden administration made an agreement with the GOP-majority House to reduce future funding by $20 billion.

Tax Gap Expands as More Companies Exploit Ways to Hide Income

Unreported business income on individual income taxes, which includes the type of income that are lost through partnerships, is one of the largest segments of the “tax gap”—the amount which the federal government is annually owed in taxes but fails to collect.

“With at least half a trillion in unpaid taxes annually, the new IRS Tax Gap estimates confirm the urgent need for investments in the IRS to ensure taxes owed are taxes paid,” Senate Finance Committee Chair Ron Wyden (D-Ore.) said in a statement last October.

“Importantly, IRS acknowledges that it underestimates tax avoidance by the wealthiest Americans and corporations.”

The shortfall, which is measured every three years, saw the tax gap rise $58 billion to $496 billion for the three-year period ending in 2016, from $438 billion between 2011 and 2013.

The total amount of annual taxes owed to the government also increased over that period to $3.3 trillion from $2.68 trillion.

The IRS reported that its estimates that the tax gap for personal business income was at $130 billion annually for tax years 2014 to 2016.

That was the last year the tax gap was formally measured. It is likely to be much higher in 2023.

The gross tax gap was about $500 billion during those years. But former IRS commissioner Charles Rettig told Congress last year that it could be as much as $1 trillion.

“The IRS made clear that the report does not adequately capture sophisticated avoidance schemes favored by billionaires, including partnerships, other pass-through entities, and secret offshore accounts,” said Sen. Wyden.

“Here’s a key point: Noncompliance in these areas is extrapolated from audits, and audits in these areas are at historic lows. There’s clearly far more avoidance at the top that IRS needs to pursue.”