IRS watchdog cites resource limits, duplication in partnership audits

Limited resources and a duplicative review process contributed to IRS problems with auditing large partnerships, a government watchdog said in a review issued earlier this month.

The Treasury Inspector General for Tax Administration (TIGTA) reviewed two IRS initiatives. One was the IRS sending Letter 6585, Soft Letter Pass-Through Entity Campaign, to 483 partnerships whose balance sheets contained a discrepancy. The other was the examination, or audit, of 82 of the largest U.S. partnerships.

Soft letters

The soft-letter campaign resulted in no responses to 163 letters, IRS rejection of 182 responses, and acceptance of 138 responses. In April 2024, the IRS decided not to examine any of the partnerships, citing resource limitations and lack of time remaining before the statute of limitations ran out, the report said.

“We believe the decision not to conduct examinations on partnerships that did not respond or whose responses were rejected presents a fairness issue and a burden for partnerships who potentially spent time and money responding to the letter,” TIGTA wrote.

Duplication occurred when two revenue agents examined responses consecutively, rather than concurrently, as originally planned, TIGTA said. The duplicative levels of review “significantly extended the review process,” the report said.

The IRS agreed with TIGTA’s recommendation that the Large Business and International Division (LB&I), which handles partnerships, “should ensure that future initiatives involving complex tax returns do not duplicate steps in the compliance risk analysis process and consider the statute of limitations to allow examiners sufficient time to review and take appropriate compliance actions.”

Large Partnership Compliance Program

Because of limited resources and decisions about modeling based on a partnership’s fiscal year, some partnerships escaped review, TIGTA said.

LB&I “is attempting to enhance the partnership compliance process by using AI and experienced tax experts to add more sophisticated risk assessment and identification of examination issues,” TIGTA said. “Although this effort is in its initial stages, the risk of not including all partnership returns in the [Large Partnership Compliance (LPC)] Program, regardless of the taxpayer’s fiscal year-end, provides an opportunity for large partnerships to evade a layer of review and reduces their examination potential. Running the model more than once to account for fiscal year filers ensures comprehensive coverage for large partnership returns.”

The IRS agreed with TIGTA’s recommendation that LB&I “should develop procedures to ensure that all large partnership returns filed throughout the year are considered for risk assessment by the LPC Program.”

Returns for 43 of the 82 partnerships under review were still being examined as of December. Thirty-six examinations were closed, and three had not yet been assigned to an examiner, TIGTA said. Of the closed examinations, 92% were no-change determinations, meaning that the examination produced no adjustments to the partnership’s return. “Although preliminary, these results indicate that the IRS may need to continue to further refine its selection models to ensure that it is selecting returns with the highest compliance risk,” TIGTA said.

The IRS has traditionally experienced high no-change rates on closed partnership examinations. “High no-change rates may be a measure of inefficiency, because the IRS expends time and resources on the examination but makes no adjustments to the taxes owed,” TIGTA said.

Partnerships and the tax gap

Accurate reporting by partnerships could help close the tax gap, which is the difference between what taxpayers owe each year and what they pay on time. Underreported income attributed to entities such as partnerships, S corporations, estates, and trusts is estimated at $42 billion of the $539 billion of the tax gap that is attributed to underreporting. However, the IRS has said that tax gap estimates for partnership income may be understated because of the difficulty in detecting sophisticated forms of noncompliance by examinations.

Also, the $42 billion does not include amounts reported on Schedules K-1 (Form 1065), Partner’s Share of Income, Deductions, Credits, etc., such as interest, dividends, capital gains, and royalties, which are included in other parts of the calculations for the tax gap, which totaled $696 billion for tax year 2022.

Inflation Reduction Act and staff cuts

The IRS initially received $79.4 billion in supplemental funding when the Inflation Reduction Act of 2022, P.L. 117-169, was signed into law. Some of that money was intended for enforcement activities for large partnerships. As of February 2026, Congress had reduced Inflation Reduction Act funding to about $26 billion, cutting $41.8 billion from the enforcement funding activity, the report said.

IRS staff cuts resulted in the loss of 20% of the 1,079 workers in the pass-through entities program, TIGTA said.

IRS data showed that the number of returns filed by partnerships with at least $10 million in total assets increased from 140,577 returns for tax year 2011 to 334,686 returns for tax year 2023. The examination rate for these partnerships decreased from 2.7% to less than 0.1% during the same period.

The report said that the IRS believed that with the original levels of Inflation Reduction Act funding, the partnership examination rate would rise to 1% in tax year 2026, when filings were projected to increase to 469,800.

“The IRS has not estimated the impacts of the rescission and workforce reductions on its ability to conduct partnership examinations. According to LB&I management, they will need to reassess their exam coverage goals for large partnerships following the reduced staffing,” the report said.

— To comment on this article or to suggest an idea for another article, contact Martha Waggoner at Martha.Waggoner@aicpa-cima.com.