Top 5 Things You Need to Know about Changes to Partnership Audit Rules
On November 2, 2015, Congress passed the Bipartisan Budget Act (“BBA”). The BBA established a new partnership audit regime and entirely repealed the current partnership audit rules under the Tax Equity and Fiscal Responsibility Act (“TEFRA”) and the electing large partnership rules.
Among other things, the new rules greatly enhance the ability of the Internal Revenue Service (“IRS”) to audit partnerships by allowing the IRS to make assessments against and collect taxes from the partnership itself. As a result, the new rules, which take effect for partnership taxable years beginning on or after January 1, 2018, will have significant implications for all partnerships and their partners.
(NOTE: The new partnership audit rules also apply to limited liability companies (“LLCs”) that are treated as partnerships for federal tax purposes. For simplicity, we will refer to partnerships and partners, but these terms also include LLCs and members, respectively.)
What changes will most likely have the biggest impact? These are the top five things you need to know about the new partnership audit rules.
1. These rules apply to ALL partnerships.
Currently, certain small partnerships with 10 or fewer eligible partners are automatically outside the scope of the TEFRA rules. As of January 1, 2018, all partnerships, regardless of size, will be subject to the BBA rules. Certain partnerships may be able to elect out of the new regime. However, if such an election is not made, the new audit rules will apply to that partnership.
The IRS has indicated that it intends to scrutinize elections out, which may result in a partnership believing it has elected out only to discover that the IRS has invalidated the election. Additionally, there are several criteria a partnership must meet in order to be eligible to elect out, and a partnership may inadvertently fail to satisfy one of these requirements at some point in time. As a result, it’s crucial for all partnerships and partners to be aware of these rules and to plan for the possibility that the rules may apply to some or all of a partnership’s taxable years.
2. You may be able to elect out of these rules.
A partnership that furnishes 100 or fewer Schedules K-1 for a partnership taxable year may elect out, provided that its partners consist only of individuals, C corporations, foreign entities that would be treated as C corporations if they were domestic entities, S corporations, or the estate of a deceased partner. Any partnership that has partnerships, trusts, disregarded entities, nominees, ineligible foreign entities, or other estates as partners will not be allowed to elect out.
Additionally, for partnerships with S corporations as partners, the partnership must count both the S corporation and each shareholder of the S corporation in determining the 100 or fewer threshold. For example, if an S corporation with five shareholders is a partner, then the partnership will be deemed to furnish six Schedules K-1 for purposes of determining eligibility for the election out.
The election must be made with a timely filed return for each taxable year for which the partnership would like to elect out. So, even if a partnership elects out for its 2018 taxable year, it must continue to elect out every year thereafter. Additionally, the election must disclose the name, Tax Identification Number (“TIN”), and federal tax classification of each partner. If any partner is an S corporation, the names, TINs, and federal tax classifications of each shareholder of the S corporation must be included, too. The election must also contain an affirmative statement that each partner is an eligible partner. Finally, the partnership must notify each partner within 30 days of making the election. Failure to comply with any of these requirements will be grounds for the IRS to invalidate the election.
3. The partnership representative is completely in charge.
A partnership must designate a partner or other person with a substantial U.S. presence to act as the partnership representative. A person is considered to have a substantial U.S. presence if that person is available to meet face-to-face with the IRS in the U.S. at a reasonable time and place, has a street address in the U.S. and a telephone number with a U.S. area code, and has a U.S. TIN. If the partnership representative is an entity, a designated individual must be appointed by the partnership as the sole individual to act on behalf of the partnership representative. The designated individual must also have a substantial U.S. presence.
The designation of the partnership representative, and designated individual if applicable, is generally made on the partnership return for each taxable year and is effective on the date the partnership return is filed. If the partnership does not designate a partnership representative, the IRS may select any person to act as the partnership representative. The partnership representative, or the designated individual if the partnership representative is an entity, has the sole authority to act on behalf of the partnership. The partnership and all its partners are bound by the actions taken by the partnership representative.
4. Partners have no right to participate in any way.
Any adjustments to a partnership’s items of income, gain, loss, deduction, or credit, and any partner’s distributive share thereof, are determined at the partnership level. A partnership’s items of income, gain, loss, deduction, or credit include all items and information required to be shown or reflected on a return of the partnership, as well as any information in the partnership’s books and records for the taxable year. The IRS has broadly interpreted this to include items related to a disguised sale, a partner’s basis in its partnership interest, and whether someone is a partner in the partnership. Additionally, the applicability of any penalty is determined only at the partnership level. No defense to any penalty may be raised by a partner, even if the defense is dependent upon the facts and circumstances of that partner.
Even though the new rules greatly impact them, partners have no right to participate in an audit in any way. There are no statutory or regulatory provisions requiring either the IRS or the partnership to notify partners of an audit proceeding, and the partners have no ability to deal with the IRS during the course of an audit or seek judicial review of any adjustments or other determinations.
5. The partnership may be liable for tax.
The default rule under the BBA is that the partnership will pay any tax resulting from the partnership-level adjustments made during an audit. This tax, referred to as the imputed underpayment, is calculated by multiplying the net of the partnership adjustments by the highest statutory rate in place.
Under the new rules, there is a possibility that the imputed underpayment may not reflect the correct tax liability of a partnership. For example, reallocations of income from one partner to another will result in an imputed underpayment based on the increase in income to one partner but will not result in a corresponding decrease to the imputed underpayment as a result of the reduction in income allocated to the other partner. In addition, if the partnership pays the tax in the year in which the audit is completed (the “adjustment year”), the partners that bear that cost may not be the same partners that were partners in the year under audit (the “reviewed year”).
A partnership has a few mechanisms it can use to reduce the imputed underpayment, as long as it follows the strict procedures for substantiating entitlement to any reduction and the IRS consents to the modification. The first is if any or all of the reviewed-year partners file amended returns taking into account all partnership adjustments allocable to those partners and pay the related tax. Another is if the partnership demonstrates that any or all of the imputed underpayment is allocable to a tax-exempt entity. A third is if the partnership demonstrates that a portion of the imputed underpayment is allocable to C corporations or individuals with a tax rate that is higher than the highest statutory rate in place. After any of these modifications are made, the partnership is liable for any remaining imputed underpayment, and the IRS will make an assessment against and collect from the partnership.
A partnership may also elect to push out the imputed underpayment and any additions, such as penalties, to the reviewed-year partners. This election must be made within 45 days of receipt of a notice of final partnership adjustment. The partnership must also provide the IRS and all partners with a statement of each partner’s share of any adjustments to items of income, gain, loss, deduction, or credit within 60 days of the final determination of the adjustments.
Under the push-out method, the reviewed-year partners calculate their share of additional tax due and pay that amount with their respective current-year tax returns. The tax due from a reviewed-year partner is computed by taking into account the amount by which the tax reported on the return for the reviewed year would increase, with adjustments for tax attributes for later years that would increase the amount of tax due. Alternatively, partners may elect to pay a safe harbor amount of tax rather than running the adjustments through all the intervening tax years.
If a partnership elects this push-out method, the interest rate charged to the reviewed-year partners is increased by two percentage points. Even though the partners are liable for the tax in this scenario, they still do not have any right to participate in the audit or seek judicial review.
What Can You Do?
If you haven’t reviewed your current partnership agreements yet, it’s best to review them sooner rather than later. You should talk to your trusted accounting and legal counsel to see how your current partnership agreements hold up under the new audit rules.
If you have specific questions about how the new rules will likely affect you or you just want a fresh perspective and advice on your current partnership agreements, reach out and just start the conversation with Anne Oliver, JD, LLM, in Tax Services. If you get even one new idea from the conversation, it will have been worth your time.
For More Information
Anne Oliver, JD, LLM, and Sarah McGregor, CPA, deliver the informative webinar, “Overview of the Partnership Audit Rules,” on Wednesday, December 13, 2017, from 1:30-2:30 p.m. Registration is free, and you get one hour of CPE!
The learning objectives Anne and Sarah will cover include how to:
- Realize the far reaching impact of the new partnership audit rules
- Identify issues and opportunities for adjusting partnership agreements
- Apply guidelines for choosing to opt out of the new regime
This program is designed for managing partners, general partners and investors in partnerships.
Sign up for this free webinar about new partnership audit rules to reserve your space.