The Internal Revenue Service (IRS) is intensifying efforts to combat the abusive use of partnerships and other pass-through entities, such as partnerships and S-corporations, zeroing in on high-income individuals and businesses.
Partnerships and S-corporations are considered pass-through entities for federal tax purposes. Unlike corporations, they don't pay corporate income tax. Instead, their profits or losses are "passed through" to their owners, who report them on their individual or corporate income tax returns.
In a June 2024 announcement, the IRS stated that "partnerships represent an area where complex business structures have allowed millionaires and high-income earners to avoid paying what they legally owe while average taxpayers play by the rules.”
As a firm that handles matters of tax controversies and IRS audits, Hendershot Cowart P.C. is working with a growing number of clients being targeted during this period of increased enforcement. As we continue to offer our support to those facing compliance actions, we’ve also put together information to help high-income taxpayers with potential exposure understand what’s happening.
Who Is in The Crosshairs?
The IRS is using artificial intelligence (AI) to focus audit efforts on complex partnerships, joint ventures, and S-Corps with discrepancies between end-of-year balances compared to the beginning balances the following year.
“The number of such discrepancies has been increasing over the years. Many of these taxpayers are not attaching required statements explaining the difference,” stated the IRS.
Partnerships at risk of audits extend across a range of entities, including hedge funds, real estate investment partnerships, publicly traded partnerships, large law firms, and others.
What’s the IRS Looking For?
The IRS is zeroing in on several key areas of concern in these audits:
- Basis-Shifting Transactions: Transactions that manipulate taxable income by shifting it between parties or tax years to reduce overall tax liability.
- Balance Sheet Discrepancies: Large discrepancies between end-of-year and beginning-of-year balances can indicate misreported income or hidden assets.
- Complex Tax Structures: High-income taxpayers have often used the intricacies of partnerships and pass-through entities to conceal taxable income. The IRS is now leveraging AI and collaboration with data scientists to dissect these complex structures.
Complex Partnership Audits Have Already Begun
In the latest wave of enforcement, according the IRS news release, the agency has commenced audits on 75 of the largest partnerships in the country, each with average assets exceeding $10 billion, followed by compliance letters to another 500 partnerships.
This aggressive approach comes as part of a broader effort to enforce compliance in an area that has historically been under-audited. Due to budget cuts over the past decade, the IRS has had difficulty allocating sufficient resources to focus compliance resources on partnerships.
“Tax filings from pass-through businesses with more than $10 million in assets jumped to nearly 300,000 filings in 2019, 70% more than 2010. At the same time, audit rates fell from 3.8% in 2010 to 0.1% in 2019,” per the IRS.
Now, backed by funding from the Inflation Reduction Act, the IRS has stepped up compliance efforts, even establishing a new examination group dedicated to pass-through organizations.
What Is an IRS Compliance Letter?
Receiving an IRS compliance letter indicates that the agency has identified potential issues with your tax filings but has not yet initiated a full audit. Compliance letters are a proactive measure, giving taxpayers an opportunity to address discrepancies before further enforcement actions are taken.
It’s important to note that while a compliance letter is not an audit, ignoring or mishandling the response could trigger one. The IRS encourages voluntary compliance, which allows taxpayers to resolve issues without immediate penalties.
More details on the IRS voluntary compliance program can be found here.
What to Do if You Receive an IRS Compliance Letter
If your partnership receives a compliance letter, here’s what you need to do:
- Review the letter in detail: Understand exactly what the IRS is flagging, whether it’s a balance sheet discrepancy, basis-shifting transaction, or another issue.
- Consult a tax attorney: Navigating IRS compliance matters without legal guidance can expose you to greater risk. Our firm specializes in helping high-value partnerships manage these inquiries efficiently and effectively.
- Prepare for a potential audit: Even if the letter doesn’t escalate into an audit immediately, preparing your financials for potential scrutiny is a wise move. Comprehensive documentation will position you to defend against any further IRS actions.
What If You’re Audited?
The IRS’s renewed focus on partnerships means audits are becoming more common – and more complex – for high-value entities. If you’re selected, the stakes can be high: penalties, interest, and even criminal prosecution. With the complexity of pass-through entities and the IRS’s new data-driven approach, having skilled legal representation is more important than ever.
At Hendershot Cowart P.C., our team has a deep understanding of these intricate tax structures. We help clients navigate the complexities of IRS audits, defend against allegations of tax avoidance, and protect their business interests.
For more detailed steps about dealing with an audit, read our Business Owner’s IRS Audit Survival Guide.
Questions? Hendershot Cowart P.C. Can Help.
Our award-winning attorneys at Hendershot Cowart P.C. bring decades of experience to the table, particularly when it comes to complex tax disputes involving partnerships and high-income taxpayers. We understand the stakes and are equipped to handle the sophisticated challenges posed by IRS audits and compliance inquiries. If your business is in the crosshairs of increased scrutiny, we can provide the strategic counsel needed to navigate these regulatory waters.
Call (713) 909-7323 or contact us online to speak with a lawyer. We serve clients across Texas and beyond.
