In recent years, the IRS has been focusing its attention on large partnerships, launching its Large Partnership Compliance (LPC) program in 2021 to audit some of the largest and most complex partnership tax returns. The program was later expanded using artificial intelligence to include more partnerships. In September 2023, the IRS announced the establishment of a designated pass-through group within its Large Business and International (LB&I) division to continue its focus on large partnerships, aiming to prevent high-income earners from using pass-throughs to shield income and avoid taxes.
On May 2, 2024, the IRS updated its Strategic Operating Plan to increase audit rates of large partnerships with assets over $10 million nearly ten-fold compared to historical rates. With an increased budget and more liberalized partnership audit rules, the IRS’s warnings of cracking down on large partnerships are not unexpected. Taxpayers may wonder what partnership items are more likely to lead to an audit. Large and unusual items naturally increase audit risks, but the IRS also provided hints at potential red flags, such as questionable balance sheet items and discrepancies and non-compliance in large partnership balance sheets.
The IRS announced on January 12, 2024, that it was aware of ongoing discrepancies in large partnership balance sheets, which could indicate potential non-compliance. Partnerships with questionable balance sheet items should be cautious as the agency may use this as a tool for audit selection. In November 2023, the Tax Court ruled in Soroban Capital Partners LP v. Commissioner that the limited partner exception for self-employment taxes does not apply to limited partners actively participating in the partnership’s trade or business. The IRS plans to increase compliance efforts on limited partners claiming exemption from SECA taxes, following their win in the Soroban Capital Partners case.
Partners should also be aware of the IRS’s focus on distributions in excess of outside basis, where a partner does not recognize gain on a cash distribution unless it exceeds their adjusted basis in the partnership. The LB&I announced an active campaign for distributions exceeding a partner’s basis in August 2022, emphasizing the need for partners to maintain good records and be prepared to substantiate their outside basis in case of an audit, particularly after large cash distributions in specific tax years. The IRS’s continued efforts to increase compliance and crack down on large partnerships indicate a shift in focus towards bringing more transparency and accountability to these entities to ensure tax obligations are met.
In conclusion, as the IRS intensifies its scrutiny on large partnerships, taxpayers should be proactive in reviewing their partnership items and ensuring that their tax reporting is accurate. The agency’s recent initiatives and updates to its audit rates and focus areas highlight the importance of maintaining proper records, complying with tax laws, and being prepared for potential audits. By staying informed about the IRS’s priorities and potential red flags in partnership tax returns, taxpayers can mitigate audit risks and ensure compliance with tax regulations.
