The Internal Revenue Service Needs To Reconsider Its Examination Strategy for Certain Partnership Returns

GGD-80-98: Published: Sep 5, 1980. Publicly Released: Sep 5, 1980.

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A GAO study of the Internal Revenue Service (IRS) administration of the partnership tax laws dealt with the IRS program for examining traditional partnerships as opposed to those partnerships established for tax shelter purposes. The report discusses IRS processes for setting examination goals and developing discriminate function system formulas for identifying those traditional partnership returns most in need of examination. Since 1978, IRS has given greater emphasis to examining partnership returns. This resulted primarily from increased use of partnerships for tax sheltering purposes and IRS wanting to have an aggressive program for identifying those programs that violate the law. The program included a doubling of its examination goal and increased use of an approach in which the partnership return is the starting point for many examinations. IRS also separated partnership returns into four audit classes. IRS generally equated the partnership class with losses of $25,000 or more with tax shelters, and equated the remaining classes with traditional partnerships. IRS reasoning was that traditional partnerships are usually formed to generate a profit while shelter partnerships are usually formed to generate a loss.

About one of every two examinations of traditional partnerships analyzed during the period of the study resulted in no change to the return filed. Two underlying factors which contributed to this were (1) the lack of data needed to determine a proper level of examination effort, and (2) the lack of data needed to develop effective discriminate function system formulas for identifying returns with the highest potential for change among all those filed. The present four audit classes are not the proper planning basis to separate tax shelter from traditional partnership returns. Many returns within the traditional partnership audit classes have tax shelter potential. There is a need for IRS to improve its procedures for rating the audit potential of partnership returns. Because IRS has developed new information indicating that the number of tax shelter partnerships may be much larger than previously suspected, there is a need for the agency to reassess its overall partnership audit plans. IRS has to come to grips with the question of whether resources previously planned for the audit of traditional partnerships should be diverted to the now larger universe of suspected tax shelter partnerships. IRS has done little since 1978 to gather the data needed to set appropriate goals and to develop an effective system for selecting returns for examination.

Recommendation for Executive Action

  1. Status: Closed

    Comments: Please call 202/512-6100 for additional information.

    Recommendation: IRS should reconsider its examination strategy for partnerships. The Commissioner of IRS should first decide whether the partnership program should continue to address traditional partnerships. If the answer is yes, he should better distinguish between traditional and tax shelter partnerships so that respective goals can be set and accomplishments measured with more precision. He should develop the voluntary compliance and cost/yield data necessary for establishing appropriate partnerships, and develop a system for more effectively identifying those traditional partnership returns having the greatest potential for change.

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