Partnership Audits Could Sacrifice Equity for Simplification

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Oct. 29 — New rules for auditing partnerships included in the budget deal moving through Congress could promote simplifying the process for the IRS at the expense of fair treatment to partners, practitioners said.

“This proposal sacrifices equity for possible simplification,” Michael Grace, counsel at Whiteford Taylor Preston LLP, told Bloomberg BNA Oct. 28. “What troubles me is that it doesn't take into account changes to the partnership between the year examined and the later year when the adjustment is being made.”

The government is increasing the scrutiny of partnerships that have been audited at much lower rates than similarly sized corporations. Provisions in the budget deal make it easier for the Internal Revenue Service to audit partnerships by collecting tax adjustments at the entity level, rather than from individual partners. This “fundamentally” changes the fact that partnerships generally pass tax liabilities on to their partners, Grace said (208 DTR G-2, 10/28/15).

Paying Another's Tab

The audit regime, which could subject partners to pay tax for years they didn't have an ownership stake, would be most notable in partnerships where there is high turnover, such as master limited partnerships or hedge funds.
Investors in these entities tend to buy and sell stakes frequently, Daniel Dunn, a partner at Dechert LLP in New York, told Bloomberg BNA Oct. 29.

“It would seem unfair, I should suffer a liability that should've been someone else's,” said Dunn, who represents investment fund clients. “To add insult to injury, that person could be in a position to go get a refund.”

Dunn said there could be an increased reliance on representation and warranty insurance, tax indemnity and clawback provisions in partnership agreements, which partners will likely revise in light of a new regime.

“Fund documents were drafted under a completely different set of rules. Most funds are going to want to do a review of fund documents,” Dunn said. “Nobody anticipated this could be a real mass issue.”

Nothing to See Here

The provisions that tighten tax compliance and streamline the auditing process are estimated to raise $9 billion, according to the Joint Committee on Taxation. Dunn suspects that private equity could be a target at the IRS, but he said there aren't many aggressive tax positions to find (209 DTR G-2, 10/29/15).

“Most of them tend to be pretty conservative,” Dunn said. “The last thing they want to do is take a position that might get audited later. Those returns flow through the investor. It becomes an investor relationship issue.”

The government is usually suspicious of private equity and Wall Street, Dunn said, but corporations are usually willing to take on more tax risk than funds. The IRS could glean insight on where hidden revenue may be by looking at the income statistics the agency keeps, Grace said.

“I would suspect that they would target their limited resources in those industries with the most significant growth in reported income or reported losses,” he said.

To contact the reporter on this story: Laura Davison in Washington at
To contact the editor responsible for this story: Brett Ferguson at