Basketball just wrapped up its season and hockey is in the last period of its season, but there is no summer vacation for the IRS Large Business and International (LB&I) division. The IRS recently announced a new enforcement campaign that targets and investigates sports industry partnerships reporting significant tax losses. Through this campaign, the IRS plans to audit the deductions that drive tax losses for these partnerships and whether they are reported in compliance with the Internal Revenue Code and related regulations.
Background
The IRS's interest in sports team owners may stem from a 2021 Pro Publica article explaining how owners of professional sports franchises can generate significant tax savings through their ownership. For example, owners may deduct their share of the franchise's losses every year against their income from other sources, which will significantly lower their tax burden.
The IRS provided no details about what specific issues it plans to investigate in the sports industry audits, but some issues that may arise are whether the owner is a material participant in the franchise and whether the owner operates the team with a profit motive. The partnerships are likely subject to the procedurally complex partnership audit rules that present thorny issues, including the default rule to impose a partnership-level tax (called the imputed underpayment). The unique way in which the imputed underpayment is calculated generally make it significantly higher than the tax would be if paid by the partners.
Related IRS Enforcement Campaigns
The sports initiative is consistent with other audit campaigns introduced since the Inflation Reduction Act of 2022 (IRA) allocated $80 billion to the IRS for enhanced enforcement. The IRS has determined that focusing enforcement and additional audit resources on the wealthiest taxpayers, corporations and partnerships will result in the greatest additional tax revenue. By 2026, the IRS plans to audit 16.5 percent of individual taxpayers with total positive income over $10 million – more than a 50 percent increase from the 11 percent it audited in 2019. In addition, the IRS has announced other campaigns targeting the wealthiest taxpayers, including audits of high-net-worth taxpayers claiming business deductions for the use of private jets.
Four Tips for Handling a Sports Partnership Audit
If a sports partnership receives the notice of selection for examination, the partnership should:
- Engage Outside Tax Counsel. Counsel will protect the privilege of communications with the return preparer, navigate IRS procedures and ensure consistent and clear messaging with the IRS. This can be particularly important if the partnership is subject to the new partnership audit rules that, as noted above, are complex and new to both taxpayers and IRS agents.
- Determine Whether the Partnership is Subject to the Centralized Partnership Audit (BBA) Procedures. If so, the partnership will want to determine who the partnership representative currently is and whether a change is necessary. The partnership representative can extend the statute of limitations, protest the adjustments and settle with the IRS. The partnership representative's actions bind the partnership and the partners regardless of any restrictions in the partnership agreement. It is common to change the partnership representative if the partnership representative is no longer a partner.
The partnership will also want to consider whether to file an administrative adjustment request (AAR) – the equivalent of a partnership amended return. The partnership has a very short window after the notice of selection for examination to file an AAR to correct an item on the original return. The partnership may want to file an AAR to correct a mistake because it can push out the adjustments to the audit-year partners without the partners paying "hot" interest (i.e., interest at an increased rate) and reduce the imputed underpayment by taking into account the partners' tax positions without IRS approval.
There are certain issues (such as material participation) that must be determined in a partner audit and not a partnership proceeding. The partner and partnership should be mindful of whether the IRS is examining the issue in the correct proceeding because, if not, there may be procedural defenses available.
- Consult the Partnership Agreement. Partnership agreements often require that the partners be notified of an audit. The partnership will want to consult the partnership agreement for notice requirements and other audit-related obligations or restrictions.
- Know the Process and the Partnership's Rights. There are various rules that govern the audit, and the partners and partnership will want to be aware of them to push back when those rules aren't followed. For example, an IRS agent is required to draft issue-focused information document requests (IDRs) and discuss their contents and the deadline for responding with the taxpayer before issuance.
If the taxpayer is having difficulty with the revenue agents assigned to the audit – whether it's on a substantive issue, communication or compliance with the procedural rules – the taxpayer can elevate and discuss with the manager. This can give the IRS a fresh perspective, reset expectations and communication, or allow the manager to overrule a decision by a revenue agent on a substantive issue. When elevation is used judiciously, it can be a very helpful tool.
At the end of the audit, the taxpayer will have the right to appeal any adjustments to the IRS' Independent Office of Appeals. This can be a great opportunity to settle issues based on the hazards of litigation. The appeals officer will not have been involved with the audit and can provide a different perspective from the exam team.
Holland & Knight Partners Keith P. Carroll, C. Anthony Mulrain and Tyrone P. Thomas contributed significantly to this alert.
