Generally, partnerships, S corporations, and other pass-through entities are at minimal risk for an audit since these entities do not have a tax liability. Instead, they pass their profits and losses to the owners who then report them on their income tax returns. The examination of these pass-through entities affects the amount of recommended additional tax for the owners’ personal income tax returns.

Audit Statistics:

According to the 2016 IRS Data Book, the IRS audited .7 percent of all individual income tax returns and .4 percent of all partnership returns filed in calendar year 2015. During fiscal year 2016, the IRS assessed $54,171 in penalties associated with failure to file Form 1065-B (large partnership return) electronically as well as the
failure to provide necessary information on Forms 1065 (partnership return) and 8752 (required payment or refund for an S corporation or partnership under Internal Revenue Code section 7519).

Types of IRS audits:

A correspondence audit is when the taxpayer receives a written notice about the tax return issues. The taxpayer is required to respond in writing. This is the least severe type of audit.  An office audit is when the taxpayer receives a letter to invite him/her to meet with the agent at a local IRS office. Usually, the IRS agent wraps everything up in one day with the office audit. Therefore, the taxpayer needs to bring all necessary financial records and tax returns to the IRS office.

A field audit is when the taxpayer is required to meet with the examiner face-to-face at the taxpayer’s place of business, the taxpayer’s home or at a local IRS office to review the taxpayer’s financial records and tax return. The taxpayer can request to have the audit done at the CPA’s office. This is considered to be a more severe type of audit as the IRS wants to examine other issues.

Tips to avoid Tax audits:

1. Do not mix personal and business deductions.  Business owners often incorrectly combine their business expenses with their personal expenses such as travel, entertainment, personal use of auto or other costs (cell phones, merchandises, etc.).

2. Payments to Partners must be capitalized, deducted, or distributed correctly. It is common to see payments or reimbursements to partners that are improperly deducted during the early years of a partnership. Examples of payments to partners include organizational expenses, start-up costs, and capital assets.

3. Ensure that guaranteed payments are accounted for and not expensed. Generally, if the partner works exclusively or primarily for the partnership, payments are more likely to be treated as guaranteed payments per IRC Section 704(c). Guaranteed payments cannot be expensed.

4. Do not treat a partner as an employee. The IRS does not allow a partner to be both a partner and an employee. See #3 above which discusses guaranteed payments.

5. Keep track of services and hours performed related to rental real estate.  During the examination, the IRS will go through the rental activities to determine if the partner materially participates or not.

6. Ensure that the partnership agreement shows the allocation of income or losses to family members properly. Also, it should include the reasonable compensation amounts for those providing services to the partnership.

7. Generally, partners do not recognize gain or loss when they receive distributions from a partnership unless it is cash in excess of basis. Although the general rule aims to treat partnership distributions as nontaxable events, it is possible for a partner to recognize gain when he/she receives cash distributions with zero basis.

8. Use a CPA or tax professionals. For any type of IRS audit, be sure to consult with your CPA or tax professional. Representing yourself or your company in an IRS audit may cost you more time and money.  Although the chance of a partnership getting audited is fairly low from a statistical standpoint, it still makes sense to be prepared for audit questions from the IRS and ensure that your business has properly documented financial records and tax returns. If you’re worried about your audit risk, please give us a call.