Budget deal takes small steps to combat large partnerships

The budget agreement reached this week by outgoing House Speaker John Boehner and President Barack Obama takes a small but useful step toward preventing tax avoidance by large partnerships. But it doesn’t go far enough and misses a much simpler solution—giving the IRS more resources to enforce current law.

Last year, the Government Accountability Office found that the IRS avoided auditing large partnerships (generally those with more than 100 partners)—notwithstanding the explosive growth of these firms over the last decade. The agency simply does not have the staff or expertise to unravel these large entities, which often have partners that are themselves partnerships, resulting in multiple tiers of these entities.  As the GAO and I testified to the U.S. Senate, the IRS is stymied by the complex organization, operations, and strategies of these large entities.

The tentative budget deal, which the House could vote on later today, would create a new regime to audit large partnerships which now are largely free from IRS oversight.  The measure would allow the IRS to examine the partnership’s income, gains, losses, deductions, and credits—and require the partnership (not the individual partners) to take into account any adjustments in the year that the audit is completed.  The agency also would collect any additional taxes directly from the partnership—rather than from the partners.  In general, the IRS would collect a tax on any income adjustment at the top individual rate, but the IRS would have to reduce the tax if an income adjustment is allocable to a tax-exempt partner.

It's surely easier to audit and collect a tax from a large partnership rather than individual partners to whom the income flows through.  But the IRS would still lack the resources to identify and pursue complicated tax issues. The new audit regime would help but there is a better solution:  give the IRS more money to do its job, something this budget agreement would not do.

Furthermore, the deal would still leave the door open for partnerships that want to avoid the new oversight.  Specifically, a partnership could keep below the 100-partner threshold by combining some of its partners under the umbrella of an S corporation, which could be a single partner.  In addition, the budget deal would direct the IRS to write rules to allow some partnerships to continue to pass through any income adjustments to their partners—and force the IRS to pursue these partners directly.

Assigning income to--and collecting taxes from--a partnership conflicts with the pass-through nature of these arrangements, leaving large questions about whether the approach would actually work.  For example, if a partnership anticipates a large income adjustment, it might encourage its taxable partners to transfer their interests to tax-exempt entities or IRAs.  Or, conversely, if the partnership expects large losses or deductions, taxable partners might pile in.  The IRS might need to develop multiple anti-abuse rules to address these potential problems—or at least clarify the intent of the new regime.

Finally, the budget agreement would delay the effective date of the new regime by three years. That would give the IRS time to write regulations to fix kinks in new law, or even request further legislation. Of course, it could also give partnerships time to adjust to the new rules, or give Congress plenty of opportunity to delay or repeal the regime (a new tax extender, perhaps).

The agreement would revise the audit rules--and collection of any underpayment of tax--for large partnerships, but would not tax large partnerships as corporations, as some suggest.  Still, the tentative budget deal demonstrates that bipartisan tax reform is possible, at least in small steps.

This article first appeared at TaxVox.