New IRS Unit Will Target Pass-Through Entities “Of Every Size and Form”

In October 2024, the Internal Revenue Service (IRS) announced the launch of a new field operations unit that is “devoted to ensuring compliance of pass-throughs of every size and form.” While this new unit doesn’t yet have a formal name, the IRS' announcement makes clear that it will play a significant role in the agency’s enforcement efforts going forward. Enforcing compliance among high-income taxpayers—including pass-through business entities and their owners—is currently among the IRS' top priorities, and non-compliance can potentially expose entities and their owners to civil or criminal penalties.

With this in mind, owners of S-corporations (S-corps), partnerships, limited liability companies (LLCs) taxed as S-corps, and trusts need to prioritize federal income tax compliance going forward. This includes not only ensuring compliance with the Internal Revenue Code (IRC) and other federal tax laws on a go-forward basis, but the IRS tax audits for businesses will also determine if past filings present risks for civil or criminal enforcement as well.

Our Boston Tax Lawyer Explains The IRS' Focus on Pass-Through Income Tax Compliance 

So, what do pass-through entity owners need to know about the IRS' new field operations unit? The new unit will combine the resources of the IRS' existing Large Business and International (LB&I) Division and its Small Business/Self-Employed (SB/SE) Division to target pass-through entities of all sizes on a more consistent and more comprehensive basis. As the IRS explains:

“Going forward, revenue agents in pass-through field operations will be assembled into geographically based teams that are responsible for primary exams of pass-through entity returns. LB&I will be responsible for starting pass-through exams, regardless of entity size. SB/SE will continue to examine pass-through entities as part of a related exam of a tax return.

“Consolidating the case-working expertise and removing the entity-size barrier helps the IRS achieve its goal of increased audit rates in this complex area . . . .”

While the use of pass-through entities is extremely common among businesses of all sizes and in virtually all industries, the IRS views these entities as potential red flags for tax evasion and tax fraud. In the IRS' words, pass-through entities “are frequently used by higher-income groups and can be complex tax arrangements,” and, according to the IRS, “complex tax arrangements” are frequently synonymous with abusive tax avoidance schemes.

Of course, this isn’t necessarily the case, and many businesses and individuals use pass-through entities to simplify tax compliance. Yet, these entities are now on the IRS' radar, and this means that compliance needs to be a priority for all of them. With the IRS becoming increasingly reliant on data analytics and artificial intelligence (AI) to identify potential targets for audits and investigations, even fully compliant pass-through entities and owners who have no intention of misrepresenting their federal tax liability could find themselves subjected to IRS tax audits for their businesses and facing intensive scrutiny from the IRS' new pass-through field operations unit.

Underscoring the IRS' focus on pass-through entities—and high-income pass-through entities in particular—the IRS' October 2024 announcement highlighted two of the agency’s other ongoing initiatives that also prioritize enforcement in this area:

• Ongoing IRS Tax Audits for Businessesare Targeting Large Partnerships – In recent years, the IRS has initiated audits targeting “76 of the largest partnerships with average assets over $10 billion.” These include hedge funds, real estate investment partnerships, and law firms, among a wide range of other businesses. While many of these audits remain ongoing, as they close, the IRS will be shifting resources from these audits into examinations targeting smaller pass-through entities.
• New IRS Chief Counsel Office Focused on Partnerships, S-Corps, Trusts, and Estates – In parallel with the launch of the IRS' new field operations unit, the IRS' Chief Counsel Office announced the creation of “a new associate office that will focus exclusively on partnerships, S-corporations, trusts, and estates.” The Chief Counsel Office advises IRS and other U.S. Treasury personnel on legal matters pertaining to taxpayer enforcement.

The launch of the IRS' new pass-through field operations unit has been more than a year in the making. The IRS initially announced its plans to launch the new unit in September 2023. At that time, the agency wrote, “Following last August's Inflation Reduction Act funding, [the new field operations unit] will center on adding more attention on high-income and high-wealth individuals, partnerships, and large corporations that have seen sharp drops in audit rates during the past decade.”

The Inflation Reduction Act gave the IRS billions of additional dollars in funding to devote to taxpayer compliance, and the IRS has stated that it intends to use these funds as efficiently as possible. Among other things, this means targeting taxpayers with the greatest outstanding liability—including high-income pass-through entities and their owners.

Avoiding Scrutiny from the IRS' Pass-Through Field Operations Unit

Given the IRS' renewed focus on pass-through enforcement, what can—and should—partnership, S-corporation, LLC and trust owners be doing to protect their entities (and themselves)? Our Boston tax lawyer offers these strategic considerations:

1. Assessing Historical Pass-Through Tax Compliance

Owners of pass-through entities should assess their historical pass-through tax compliance over the past several years—IRS audits will go as far back as six years in some cases. With the IRS' focus on closing the tax gap through high-income taxpayer enforcement, pass-through entities and owners with substantial outstanding tax liability (as well as liability for interest and penalties) will be strong candidates for facing scrutiny from the agency’s new field operations unit.

2. Specifically Addressing Any Likely Red Flags for the IRS

Along with assessing their pass-through tax compliance generally, these taxpayers should also address any specific issues that are likely to be red flags for the IRS. Some examples of the IRS' other current enforcement priorities include:

• Charitable remainder trusts
• Cryptocurrency, gaming and gambling
• Monetized installment sales
• Offshore bank accounts
• Pandemic-era fraud (PPP and ERC fraud)
• Syndicated conservation easements
• Unlawful tax avoidance schemes

For pass-through entities and their owners, these can all increase the risk of facing scrutiny from the IRS' new field operations unit. While this new unit may be focused on pass-through compliance specifically, if revenue agents uncover evidence of other compliance issues, they will look into these issues for enforcement-related purposes as well.

3. Proactively Remedying Any Compliance Concerns

If an assessment of a pass-through entity or owner’s filing history uncovers compliance concerns, remedying these concerns proactively will be the best approach. However, what this entails will depend on the specific circumstances involved. While there are several options for proactively resolving tax controversies with the IRS, not all of these options are available in all circumstances—and choosing the wrong option can be very risky. With this in mind, some of the potential options for resolving pass-through-related tax controversies include:

• Submitting an Amended Filing – Submitting an amended filing will be a viable option in some (but not all) cases. Generally speaking, delinquent taxes, interest, and penalties will be due in full at the time of filing.
• Submitting a Streamlined Filing – Submitting a streamlined filing is an option for resolving non-willful offshore account disclosure violations. Different rules apply to different types of taxpayers domiciled in the U.S. and abroad.
• Submitting a Voluntary Disclosure – Submitting a voluntary disclosure provides an opportunity to avoid criminal prosecution for willful tax law violations. However, it can also be very risky, so an informed approach guided by an experienced Boston tax lawyer is essential.
• Submitting an Offer in Compromise (OIC) – Submitting an offer in compromise provides an opportunity to resolve outstanding tax debt for less than the full amount owed. However, eligibility criteria apply, and the IRS is not obligated to accept any offers submitted.
• Seeking a Settlement or Installment Agreement (or Both) – Taxpayers can also seek to resolve their tax debts for less than they owe by negotiating a settlement agreement with the IRS. This will prove to be the most advantageous approach in many (but not all) cases. When necessary, taxpayers can seek to negotiate installment agreements as well.

Again, these are just examples of potential options for resolving both pass-through-related and non-pass-through-related federal tax controversies. Before making any decisions about how to move forward, it is imperative that pass-through entity owners consult with an experienced Boston tax lawyer to ensure that they are making informed and strategic decisions.

4. Ensuring Compliance on a Go-Forward Basis

After remedying any enforcement concerns related to previous filings, pass-through entity owners should take the steps necessary to ensure filing compliance on a go-forward basis. This may involve working closely with an experienced Boston tax lawyer as well. While pass-through entities and their owners still can—and should—leverage tax planning strategies to their maximum effect, they should also ensure that they are prepared to clearly demonstrate compliance to the IRS if necessary.

5. Preparing for the Possibility of a Pass-Through Audit

In this same vein, owners of pass-through entities should take other steps to ensure that they are prepared for the possibility of a pass-through audit as well. While prioritizing compliance will help minimize the risk of facing scrutiny, facing scrutiny will remain a very real possibility for the foreseeable future. By putting procedures in place so that they are ready to respond effectively to an examination if necessary, entity owners can ensure that their pass-through audits proceed (and get resolved) as quickly, favorably and quietly as possible.

Responding to an Examination by the IRS' Pass-Through Field Operations Unit

Now, let’s say it is too late to avoid an examination by the IRS' pass-through field operations unit. Or, perhaps despite your best efforts, you are still facing scrutiny related to your (or your entity’s) pass-through filings. What should you do in this scenario?

If you are facing a pass-through examination from the IRS' new field operations unit, you should:

1. Engage Experienced Federal Tax Defense Counsel

In this scenario, experienced legal representation is critical. Once you find out that the IRS is targeting you or your business (or trust), you should engage an experienced Boston tax lawyer right away. This is especially true for high-income taxpayers, including both pass-through entities and their owners.

2. Promptly Address Any Immediate Concerns

Next, you should work with your lawyer to promptly address any immediate concerns. These include impending visits from IRS personnel and requests for documentation with deadlines attached. In this scenario, preparation and planning are essential. Oversights and other mistakes can prove very costly at this stage, and they can lead to even greater scrutiny from the IRS.

3. Conduct an Attorney-Client Privileged Tax Compliance Assessment

When facing scrutiny from the IRS, it is imperative to know what (if anything) the IRS is going to find. With this in mind, making informed decisions about your defense strategy starts with conducting an attorney-client privileged tax compliance assessment. This assessment should cover all potential areas of concern for all years covered (or potentially covered) by the examination.

4. Formulate a Comprehensive and Cohesive Defense Strategy

Once you have a clear understanding of your level of risk, then you can work with your attorney to formulate a comprehensive and cohesive defense strategy. Depending on the circumstances, this strategy may involve working to resolve the examination without additional liability, or it may involve working toward a settlement with the IRS.

5. Work with Your Boston Tax Attorney to Target a Favorable Resolution

In any case, once you have a strategy in place, you will then need to focus your efforts on working with your counsel to target a favorable resolution. At a minimum, this should involve avoiding the need to pursue an appeal and avoiding formal federal charges. While examinations targeting high-income taxpayers can present substantial risks, it should be possible to effectively mitigate these risks with the advice and representation of experienced counsel in most cases.

Schedule a Confidential Consultation with a BostonTax Attorney at Thorn Law Group

If you have questions or concerns about the IRS' enforcement initiatives targeting pass-through entities and their owners, we invite you to get in touch. We have extensive experience representing entities and their owners in high-stakes federal tax controversies and IRS tax audits for businesses. To schedule a confidential consultation with Boston tax attorney Kevin E. Thorn at Thorn Law Group, please call 617-692-2989 or tell us how we can get in touch online today.