The Heat Is on for Large Partnership Audits

Key Takeaways:

• The Internal Revenue Service (“IRS” or “agency”) will be auditing 75 of the largest partnerships, including hedge funds, real estate investment partnerships, publicly traded partnerships, and law firms, in addition to conducting 500 compliance audits of partnerships across industries
• These audits will be heavily coordinated and will use data analytics, including Artificial Intelligence (“AI”) tools
• The agency has announced that it will “stand up” a new group to focus on audits of large partnerships
• The IRS has made significant investments in hiring and onboarding staff trained in large partnership audits and has recently announced that it intends to hire 3,700 new technical employees
• Large partnership audits are a cornerstone of the IRS’s campaign to preserve appropriations under the Inflation Reduction Act of 2022 (“IRA”)

Large partnerships are facing a sea change in tax enforcement. Beginning with the Large Partnership Compliance program announced in 2021 and its most recent announcement that it intends to “stand up” a group focused on large partnership audits next year, the IRS is banking on revamped enforcement efforts targeting passthrough entities. The Government Accountability Office has criticized the IRS’s partnership audit rate – less than 1%, despite a 75% increase in large partnerships over the last decade. The IRS has announced programs to turn the tide, including (1) hiring, onboarding, and training the staff needed to achieve appropriate compliance coverage rates, and (2) leveraging data and analytics to develop effective approaches for partnership tax enforcement,¹ including the use of AI and improved technology. It is clear that the agency’s success in raising revenue from the large partnership audit initiative will be a cornerstone of the IRS’s efforts to maintain its current funding levels.

Just a few weeks ago, the IRS trumpeted its “sweeping efforts” to focus its enforcement on partnerships (as well as high-earning individuals and entities) to “restore fairness” to the tax system (IRS News Announcement). As early implementation of these initiatives has begun, audits of large partnerships have started in earnest.

Background

The IRA Strategic Operating Plan was issued earlier this year to outline the IRS’s planned deployment of funds received under the IRA. In addition to the specific initiatives outlined above, the IRS identified milestones in its goal to expand large partnership enforcement. The first milestone, unsurprisingly, is a wave of hiring dedicated to increasing the audit rate for large partnerships during FY 2023.² Later milestones include refined approaches and treatments piloted for large partnership enforcement, ideally by FY 2025.³

The September announcements (just days before partnership tax returns were due) put large partnerships on notice that more audits are coming for taxpayers in multiple industries, including hedge funds, real estate investment partnerships, publicly traded partnerships, and law firms. The use of AI to assist in these large partnership audits will give the IRS what Commissioner Werfel has referred to as “night vision goggles,” both in the identification of taxpayers and the issues to audit.

The audit initiative is a direct result of the Large Partnership Compliance pilot program announced in 2021. Under this pilot program, the IRS has begun the process of developing analytical tools and a playbook for partnership audits. One of these new tools is the Large Partnership Compliance Model (“LPCM”), which the IRS identifies as an AI tool. The LPCM was first used in April 2023 and, through the use of risk indicators and a machine learning algorithm, the IRS identified 150 large partnerships for further review by classifiers. Presumably the 75 audits announced in September are a subset of the 150 partnerships identified by the LPCM as presenting compliance risks. (Of course, the IRS also may be auditing the remaining partnerships without the unusual step of making a public announcement.)

A September 20 IRS News Release reported that part of the IRS’s new compliance effort will involve standing up a dedicated unit to focus on large or complex pass-throughs within the Large Business & International (LB&I) Division of the IRS. Although this group is not expected to be launched formally until late 2024, LB&I Commissioner Holly Paz has confirmed that work will continue to intensify prior to the official creation of the group.

Types of Audits

The IRS has announced the launch of both compliance audits (anticipated 500 compliance audits) and field examinations (anticipated 75 field examinations) of large partnerships. Compliance audits will require partnerships to substantiate return items (likely related to reconciliation of balance sheet items to the tax return).⁴ In contrast, field examinations of the 75 targeted large partnerships likely will be akin to research audits and involve a detailed and multi-year review of the partnership’s operations and tax positions.

Taxpayer Challenges

Taxpayers targeted by the large partnership audit initiative should anticipate that the IRS has conducted a robust risk analysis in advance of issuing the notice of selection for examination, likely aided by AI analysis. These partnerships should anticipate that Information Document Requests (“IDRs”) will reflect a more strategic, targeted approach than previously has been the norm in partnership audits; agents likely will have received substantial direction on issues to examine and will issue template IDRs. While it is still early in the process, to date we have seen indications that there is national coordination of large partnership audits and that agents have less discretion on which issues to pursue.

What’s Next

Certain themes are apparent in the IRS’s large partnership initiative: first, a large scale focus on understanding complex partnership structures, which leads to an intrusive audit process; second, use of technology, data, and analytics to operate more effectively; and third, the need for a highly trained and well deployed work force. Although the IRS has announced concrete steps to achieve its stated goal of “sweeping, historic efforts to restore fairness in tax compliance,” the success of its initiatives will depend on its ability to conduct effective examinations of a highly sophisticated group of taxpayers who likely have never been audited before.

¹ IRS IRA Strategic Operating Plan, FY 2023–2031 (available [here]).

² IRS IRA Strategic Operating Plan, FY 2023–2031 (available [here]).

³ IRS IRA Strategic Operating Plan, FY 2023–2031 (available [here]).

⁴ Of course, compliance audits could evolve into full-scale field audits.

This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.