Wednesday, September 13, 2017
Under the Balanced Budget Act of 2015 (BBA), P.L. 114-74, section 1101(a), 129 Stat. 584 (2015), as amended by P.L. 114-113, new partnership audit rules take effect for tax returns filed for tax years beginning on or after January 1, 2018 (although a taxpayer can elect to have the BBA provisions apply to any partnership return filed after the date of enactment, November 2, 2015).
The new rules, make it easier for the IRS to audit large partnerships by making a determination of taxes at the partnership level, ensuring that a partner's return is consistent with the partnership return. They also allow for the designation of a partnership representative. In essence, the rules allow the IRS to audit partnerships, make a tax adjustment in the year in which the audit is done, and have the general partner have the income flow through to the partners.
The IRS had been pushing for the change to a centralized partnership audit regime for some time. In general, the new process will result in the assessment and collection of tax at the partnership level and could result in more partnership audits.
One reason the new rules matter and should be paid attention to is that they could require the modification/amendment of partnership operating agreements.
Today’s post takes a brief look at the new partnership audit rules and their impact.
What is Changing?
1982 rules. The current partnership audit rules date back to 1982 and the Tax Equity and Fiscal Responsibility Act (TEFRA). Under those rules, for partnerships with 10 or fewer partners, the IRS generally applies the audit procedures for individual taxpayers, auditing the partnership and each partner separately. For partnerships with 11 to 100 partners, the IRS conducts a single administrative proceeding to resolve audit issues regarding partnership items that are more appropriately determined at the partnership level than at the partner level. Once the audit is completed and the resulting adjustments are determined, the IRS recalculates the tax liability of each partner in the partnership for the particular audit year.
For partnerships with 100 or more partners that elect to be treated as Electing Large Partnerships (ELPs) for reporting and audit purposes, partnership adjustments generally flow through to the partners for the year in which the adjustment takes effect, rather than the year under audit. As a result, the current-year partners’ share of current-year partnership items of income, gains, losses, deductions, or credits are adjusted to reflect partnership adjustments relating to a prior-year audit that take effect in the current year. The adjustments generally do not affect prior-year returns of any partners (except in the case of changes to any partner’s distributive share).
BBA provision. Under the BBA provision, the current TEFRA and ELP rules are repealed, and the partnership audit rules are streamlined into a single set of rules for auditing partnerships and their partners at the partnership level. Similar to the current TEFRA rule excluding small partnerships, the BBA provision allows partnerships with 100 or fewer qualifying partners to opt out of the new rules, in which case the partnership and partners would be audited under the general rules applicable to individual taxpayers.
The new rules allow a partnership to pay a computed tax at the end of any partnership examination rather than a tax being assessed at the partnership level. This tax will be assessed to the partnership in the year that the audit is completed (the adjustment year), rather than the year of the examination (the reviewed year). The tax will be computed at the highest income tax rate applicable to corporations and individuals (currently the individual rate, at 39.6%). I.R.C. §6221(a).
The partnership is permitted to issue adjusted Schedules K-1 to the partners of the reviewed year. The recomputed tax for the reviewed year is paid in the adjustment year. The partners take the adjustment into account on their individual returns in the adjustment year (not the reviewed year). I.R.C. §6226(b)(1).
In addition, rather than amending the partnership tax return, partnerships will have the option of initiating an adjustment for a reviewed year. The adjustment could be taken into account at the partnership level or the partnership could issue adjusted information return to each partner of the reviewed year.
A “partnership representative” replaces the former “tax matters partner.” The representative has more authority to act on the partnership’s behalf without involving the partners. The “partnership representative,” a person (or entity) must have a “substantial presence” in the United States. If it is an entity, the partnership must identify and appoint an individual to act on the entity’s behalf. While the representative doesn’t have to be a partner of the partnership, they do have the sole authority to settle any disputes with the IRS and agree to a final adjustment. The representative also can make the election to shift the tax liability to the partners, and extend the statute of limitations on assessment. But, under the proposed regulations, the representative doesn’t have to communicate with the partners or get consent from the partners before the representative acts on behalf of the partnership. Also, if the partnership does not have a representative designation in effect, the IRS can pick who the representative will be.
A “small partnership” can elect out of the new rules. A “small partnership” is one that is required to furnish 100 or fewer Schedules K-1 for the year. In addition, the partnership must have partners that are individuals, corporations or estates. If a partnership fits within the definition and desires to be excluded from the BBA provisions, it must make an election on a timely filed return and include the name and identification number of each partner. If the election is made, the partnership will not be subject to the BBA audit provisions and the IRS will apply the audit procedures for individual taxpayers. There are more specifics on the election in the regulations, but a drawback of the election might be that a small partnership electing out of the BBA audit provisions could be at a higher audit risk. IRS has seemingly indicated that this could be the case.
Proposed regulations. Proposed regulations were issued in January to replace the 1982 unified audit rules and implement the new rules, but never were published in the Federal Register because of the regulatory freeze that the White House imposed. They were reissued in June. REG-136118-15.
So, what do partnerships need to do in light of the new audit rules? One consideration might be to amend an existing partnership agreement to establish a procedure to be used when the IRS determines that the partnership has a deficiency and partners might be able to do something to reduce the tax burden. I am thinking here of situations where individual partners might have information or could take steps might be helpful to the partnership in dealing with the IRS audit of the partnership and reducing the ultimate tax burden of an additional assessment. Related to that, partnership agreements commonly include notice and consent procedures for various aspect of partnership business, so it may be beneficial to add in notice and consent language that specifically pertains to IRS audit matters under the new rules. As a caveat, however, it’s not likely that a court would determine that the IRS is bound by such language. But, the language might provide more clarity and guidance for the partnership and its partners.
The new audit rules that take effect on January 1, 2018, change the landscape for partnership audits. In some respects, the audit process will be simpler and more streamlined. In addition, the vast majority of farming and ranching partnerships will be able to elect out of the new rules. But, the election must be affirmatively made, and the proposed regulations provide detail on making the election. In any event, now is the time for partnership agreements to be amended where necessary to take into account the coming new rules.