The IRS Will Use Artificial Intelligence To Help Pick Which Large Law Firms To Audit
The IRS has not elaborated, but the vague language could be intentional in order to put many others on notice.
Last week, the IRS announced that it will use its increased funding from the Inflation Reduction Act to shift more attention to high-income individuals, partnerships, and corporations. While this announcement covered may topics, including digital assets such as cryptocurrencies, foreign bank account reporting (FBAR) compliance, and scams to name a few, it has specifically named certain large law firms for close scrutiny.
By the end of the month, the IRS will open examinations of 75 of the largest partnerships in the U.S. that represent a cross section of industries including hedge funds, real estate investment partnerships, publicly traded partnerships, large law firms and other industries. On average, these partnerships each have more than $10 billion in assets.
The IRS also plans to contact 500 partnerships via mail in early October. These partnerships have a discrepancy on their balance sheets with over $10 million in assets. The IRS believes that this discrepancy without an explanation could be an indicator of potential noncompliance.
To determine which partnerships to audit, the IRS will use artificial intelligence (AI) to help with the selection process.
With the help of AI, the selection of these returns is the result of groundbreaking collaboration among experts in data science and tax enforcement, who have been working side-by-side to apply cutting-edge machine learning technology to identify potential compliance risk in the areas of partnership tax, general income tax and accounting, and international tax in a taxpayer segment that historically has been subject to limited examination coverage.
The IRS has not elaborated on the “groundbreaking collaboration” or what the “cutting-edge machine learning technology” is, but the vague language could be intentional in order to put many others on notice. Also, the IRS keeps its selection methodology a secret. For example, the IRS uses a “discriminant function” score, commonly referred to as a “DIF score” to determine whether to audit a tax return. Taxpayers are not allowed to see their DIF scores.
Why is the IRS targeting large partnerships? Because general and limited partnerships are popular business forms for certain high-income industries, such as real estate and law firms. The tax law allows partnerships to be flexible when it comes to the allocation of profits, losses, deductions, and credits. This flexibility addresses partners that contribute differently to the partnership. Compare this to the S-corporation where shareholders are taxed solely in proportion to their stock ownership, regardless of what each shareholder brings to the joint venture. It also avoids the double taxation of C-corporations.
With this flexibility comes the potential for abuse. For example, a partner in a high-income tax bracket would want all of the deductions and credits allocated to her while the partner in a lower income tax bracket would absorb the partnership income. To mitigate this, the tax law has anti-abuse rules which generally prohibit taxpayers from using the partnership entity if its primary purpose is to shelter taxable income with no legitimate business purpose. It also requires allocations to partners to have “substantial economic effect” which generally means the partner receiving the allocation feels the economic effect of the allocation.
Partnership tax law is considered to be one of the most complicated and can confuse experienced professionals. It is also some of the most convoluted. For example, one of the Treasury regulations addressing “substantial economic effect” — commonly known as 704(b) regulations — is 144 pages long. So it is possible that noncompliance could be unintentional.
Despite this complexity, audits of partnership returns are not as successful as you might think. According to a 2022 report from the Treasury Inspector General for Tax Administration, audits of 480 partnership returns between 2016 and 2019 show a 78% no-change rate. Compare this to a 50% no change rate for all partnership returns for the same period.
For the large law firms that could in the Internal Revenue Service’s sights, it would be helpful to have a second look at their past partnership returns. Generally, the IRS has three years from the date the returns were filed to audit. But if there is a “substantial understatement of income,” meaning that the return omitted more than 25% of gross income, they have six years to audit. And if the return is fraudulent, the IRS has no time limit to audit.
Steven Chung is a tax attorney in Los Angeles, California. He helps people with basic tax planning and resolve tax disputes. He is also sympathetic to people with large student loans. He can be reached via email at stevenchungatl@gmail.com. Or you can connect with him on Twitter (@stevenchung) and connect with him on LinkedIn.
