Debt Limit Bill Changes IRS Partnership Audits
Recently, Congress passed and the president signed the Bipartisan Budget Agreement of 2015, extending the debt limit deadline and avoiding a potential government shutdown. Among other provisions, the legislation changes the way the IRS audits partnerships. The new audit treatment is mandatory for tax years beginning after 2017, but partnerships may elect treatment under the new rules immediately.
The IRS historically has applied three different rules to partnership audits, depending on the size of the partnership:
- When a partnership has fewer than 10 partners, the IRS would audit the partnership under general rules, reviewing both the partnership and each partner.
- For partnerships with more than 10 partners, the IRS would audit tax issues at the partnership level rather than the individual partner level. Under these rules—commonly called the TEFRA rules—the IRS determines the tax treatment of items at the partnership level. The IRS holds a single administrative hearing to resolve all issues related to the audit and then recalculates each partner’s tax liability for the year under exam.
- Partnerships with more than 100 partners may elect to be treated as an electing large partnership (ELP). During an ELP audit, the IRS still would audit the partnership rather than the individual partners, but the exam changes flow through to the partners’ current-year tax return instead of the tax year under exam.
The new legislation eliminates the TEFRA and ELP rules, replacing them with simplified rules applying to all partnerships. The streamlined rules ensure the IRS will audit partnerships at the partnership level and by default applies the adjustment to the partnership rather than the partners. Partnerships with fewer than 100 qualifying partners can opt out of the new rules, in which case the IRS will audit partners and partnership under the general rules applying to individual taxpayers.
When finding net unfavorable adjustments, the IRS computes the total tax due by multiplying the adjustment by the highest tax rate in effect for the year under exam. Partnerships can elect to prove that applying the adjustments at the partner level results in a lower adjustment, but the partnership is responsible for the calculations.
Rather than take the adjustment at the partnership level, a partnership alternatively may issue an adjusted Form K-1 to each partner. The partner then may adjust his or her individual return for the year in which the IRS issued the adjustment, rather than the year under exam. This would eliminate the need for partnerships to issue amended K-1s, with partners amending prior-year individual returns.
Under the new rules, the IRS allows partnerships to request an adjustment without an IRS examination. This applies in cases where the partnership finds it paid too much or too little tax and allows the partnership to take the adjustment at the partnership level or pass the adjustment to the partners for inclusion on their current-year returns.
Other changes include preventing partners from treating items on individual returns differently than on the partnership’s return. Unlike in earlier bills, partners aren’t jointly and severally liable for tax liabilities at the partnership level. Under the current rules, each partnership elects a tax matters partner to represent the partnership before the IRS. The new bill allows each partnership to elect a tax matters representative, even if the representative isn’t a partner.
For any questions on how these changes could affect you or your partnership, contact your BKD advisor.