The IRS has made clear that large partnerships and high-income taxpayers are at the top of its enforcement priority list. With approximately $80 billion in new funding from the Inflation Reduction Act, the Service is building the infrastructure to audit entities and individuals that have historically been examined at very low rates. For business owners who operate through partnerships and LLCs taxed as partnerships—which describes the majority of closely held businesses in Mississippi—this shift in enforcement posture warrants careful attention and proactive preparation.

The Enforcement Gap

For years, the IRS audit rate for large partnerships has been remarkably low. According to data published by the Treasury Inspector General for Tax Administration, partnerships with assets exceeding $10 million were audited at a rate below 0.5 percent in recent years—a fraction of the audit rate for comparable corporate entities. This disparity reflects the complexity of partnership returns, the difficulty of unwinding multi-tiered partnership structures, and the resource constraints that limited the IRS's ability to devote experienced personnel to these examinations.^[1]

The IRA funding is intended to close this gap. The IRS Strategic Operating Plan, published in April 2023, commits to significantly increasing audit coverage of large and complex partnerships, high-income individuals (defined as those with total positive income exceeding $1 million), and entities that engage in aggressive tax planning. The Service is hiring specialized agents with partnership audit experience and is investing in data analytics tools to identify returns with the highest potential for unreported income or improper deductions.

The Centralized Partnership Audit Regime

The Bipartisan Budget Act of 2015 replaced the old TEFRA partnership audit rules with a centralized partnership audit regime, commonly known as the BBA rules, which apply to partnership tax years beginning after December 31, 2017. Under the BBA regime, the IRS audits the partnership at the entity level and assesses any resulting tax adjustment against the partnership itself in the year the adjustment is finalized—the so-called "imputed underpayment." The partnership may then elect to "push out" the adjustment to its partners for the reviewed year, but the default rule imposes the tax at the entity level at the highest individual rate.^[2]

The BBA regime significantly streamlines the IRS's ability to audit partnerships by eliminating the need to separately assess each partner. For the IRS, this means that large partnership audits are now logistically feasible in a way they were not under the prior rules. For partnerships and their partners, it means that the risk of entity-level tax assessments—potentially at rates higher than the partners' actual tax rates—is real and must be addressed in partnership agreements and tax planning.

What the IRS Is Looking For

Based on public statements from IRS officials and guidance issued in connection with the IRA enforcement initiative, the Service is particularly focused on several areas. First, the IRS is scrutinizing the use of partnerships to generate losses or deductions that offset income from other sources—particularly syndicated conservation easement transactions, which we discussed in our earlier analysis of the Faulconer decision. Second, the IRS is examining basis computations and the allocation of income, deductions, and credits among partners, looking for allocations that lack substantial economic effect. Third, the Service is reviewing related-party transactions within partnership structures, including management fees, guaranteed payments, and property contributions and distributions that may be used to shift income or gain.^[3]

The IRS has also indicated that it will use artificial intelligence and advanced data analytics to identify partnerships and high-income individuals for examination. The Service is developing algorithms that can compare the information reported on partnership returns (Form 1065) with the information reported by partners on their individual returns (Schedule K-1) to identify discrepancies and patterns suggestive of noncompliance.

How Business Owners Should Prepare

For business owners who operate through partnerships or LLCs, the increased enforcement environment calls for several practical steps. First, review partnership and operating agreements to ensure they address the BBA audit rules, including the designation of a partnership representative and the procedures for handling entity-level tax adjustments. Many existing agreements were drafted before the BBA rules took effect and may not adequately address these issues.

Second, review the partnership's tax return positions to ensure they are well-documented and defensible. This includes verifying that allocations have substantial economic effect, that basis computations are accurate, and that related-party transactions are conducted at arm's length and properly documented. The cost of a proactive tax review is modest compared to the potential cost of defending an IRS examination.

Third, maintain thorough records. In an audit environment, documentation is the first line of defense. Business records, transactional documents, valuation analyses, and contemporaneous memoranda supporting tax positions should be organized and accessible. The inability to produce supporting documentation in response to an IRS information request can turn a routine examination into an extended and costly dispute.

Finally, for partnerships that engage in complex transactions—including those involving multiple tiers of entities, significant related-party dealings, or aggressive tax positions—consider engaging qualified tax advisors to conduct a readiness assessment before the IRS comes calling. The shift in enforcement posture is not a future concern; it is happening now, and the partnerships that are prepared will fare significantly better than those that are not.