Partnerships have become an increasingly popular tax structure, but they continue to increase in complexity. The existing audit rules task the IRS with examining the partnership return, but require the agency to individually notify affected partners of any adjustments needed to collect tax related to proposed changes. Therefore, the IRS found it burdensome to audit partnerships and track down individual owners, which sometimes could be hundreds of partners through multiple tiers of a complex structure.
In response to this issue, Congress passed the Bipartisan Budget Act of 2015 (BBA), which changes the way the IRS conducts audits of taxpayers filing partnership returns for tax years beginning after December 31, 2017. Under the new rules, the IRS now has authority to assess tax and any related penalties and interest at the partnership level. The new rules intend to require fewer IRS resources and lead to more partnership taxpayer audits.
Adjustments resulting in additional tax due will be calculated at the highest individual or corporate tax rate. Adjustments that don’t result in a tax underpayment will be allocated on the partnership return in the year of the adjustment.
Alternatively, the partnership may make a “push-out” election and issue an adjusted Schedule K-1 to each partner during the exam year. Each partner adjusts the return for the year in which the IRS issued the adjustment—rather than the exam year—thereby avoiding the need to file amended returns.
As of this writing, regulations surrounding these new audit rules haven’t been finalized. However, the IRS released proposed regulations in June, which are discussed in this article.
Rules for Electing Out
Partnerships with 100 or fewer partners will be eligible to elect out of the new rules and instead be subject to audit procedures in place prior to the BBA. To elect out, each partner must be an individual, C or S corporation or the estate of a deceased partner. However, having partners that are trusts, disregarded entities or other partnerships will prevent a partnership from electing out of the rules. If one or more partners is an S corp, the S corp shareholders must be individually counted to determine whether they meet the maximum partner threshold.
The election is made annually on a timely filed partnership return and must include a list of the partners along with their taxpayer identification numbers. In the case of an S corp partner, the listing also must identify each S corp shareholder. The partnership must notify each partner of the decision to elect out within 30 days of making the election. The IRS indicated it plans to scrutinize these elections to ensure they’re valid.
The regulations create a partnership representative, who replaces the tax matters partner under the old audit regime. The IRS won’t provide notice or allow any other person to participate in the negotiations with the IRS other than the partnership representative. This person isn’t required to be a partner in the partnership. Use caution when selecting the individual or entity for this role since this person has the sole authority to work with the IRS on potential adjustments and bind the partnership into agreements with the IRS. Only the partnership representative can raise defenses related to potential penalties, proposed adjustments and additions to tax. The designation is made each year on a timely filed return and only can be changed in limited circumstances.
The proposed regulations allow a partnership to correct a previously filed return by filing an Administrative Adjustment Request (AAR), which would prevent the need to file an amended partnership return and amended returns for each partner. Any additional tax is paid at the partnership level without the additional 2 percent interest imposed when the IRS proposes the adjustment. The request must be made within three years of filing the original return.
The IRS now has the authority to assess additional tax and penalties when partners treat an item differently on their tax return than how the item was treated on the partnership return. These items will be treated as mathematical errors and assessed automatically unless the partner discloses the inconsistent treatment to the IRS with a statement attached to the return.
All partnerships and limited liability companies (LLC) taxed as partnerships should consider amending their current partnership/LLC agreements. Questions include:
- Will the partnership choose to elect out of the rules every year it’s allowed?
- Who will be designated as the partnership representative?
- Under what circumstances should the “push-out” election be made?
- Will the partnership agreement require the partnership representative to communicate potential adjustments before binding the partners?
- Will the agreement allow the partnership to file AARs instead of amending returns?
The new rules substantially change the way the IRS will interact with partnership taxpayers. While the regulations surrounding the new rules are still in proposed form, they provide useful insight into how the IRS plans to implement them.