2018 Changes for Partnership Tax Audits
Jeff Storch | 09.29.17
Rules for IRS audits of entities taxed as partnerships change January 1, 2018, due to the Bipartisan Budget Act of 2015, Pub. L. No. 114 – 74 (the “Act”). This affects general partnerships, limited liability partnerships, limited partnerships, and limited liability companies taxed as partnerships. In this post, all references to “partnership” refer to any entity taxed as a partnership and “partners” to the respective owners.
If one or more of your entities could be affected, you should consider how to respond to the new rules, including whether to amend the current partnership or operating agreement.
In part, the new rules:
- Replace the “tax matters partner” with a “partnership representative,” resulting in the other partners having fewer rights in an audit.
- Allow the IRS to collect taxes upon audit from the partnership itself. This is a significant change in the historical “pass-through” nature of partnerships.
Following is more information on the partnership representative, the application of the new rules, and how certain partnerships can elect out of part of the rules. At the end, we provide a list of items to consider in responding to the new rules.
Partnership Representative v. Tax Matters Partner: Under the old rules, each partnership with more than ten partners and any partnership with certain types of partners must have a “tax matters partner.” The tax matters partner can bind all partners to settlements of partnership-level controversies with the IRS.
The tax matters partner must be a general partner of the partnership, but otherwise the old rules allow the partnership to designate its tax matters partner. If the partnership does not designate a tax matters partner one, the rules provide that it is the partner with the largest profits interest at the close of the applicable tax year.
The Act replaces the “tax matters partner” with a “partnership representative”. Changes include:
- The partnership representative may, but need not be, a partner of the partnership.
- If a partnership does not designate a partnership representative, the IRS may select any person to be partnership representative.
- The partnership representative has sole authority to act on behalf of the partnership with respect to the IRS.
Granting sole authority to the partnership representative effectively means that other partners do not have a statutory right to notice about an audit, the ability to participate in the audit, or the right to challenge the results of the audit.
Application: The Act’s audit procedures generally apply to all partnerships. However, as discussed below, certain partnerships may elect out of the procedures. It appears that many partnerships eligible to elect out will wish to do so.
Calculation of Tax on Audit: Partnerships who do not elect out (whether because they are ineligible or do not take the proper steps to do so) will be subject to the Act’s audit procedures and are liable for the taxes resulting from the audit adjustments, plus penalties and interest (the “Imputed Underpayment”).
- The Imputed Underpayment is generally calculated by netting all adjustments of items of income, gain, loss, or deduction and multiplying the net amount by the highest tax rate in effect for the Reviewed Year (defined below) for individuals and corporations, as applicable.
- The calculation of the Imputed Underpayment generally does not take into account the tax attributes of the underlying partners. This could lead to substantial overpayment of taxes if some of the partners would not be required to pay tax themselves (e.g. tax exempt organizations, taxpayers with net operating losses, or certain non‑U.S. taxpayers).
Timing of Payment – Reviewed Year v. Adjustment Year: The Imputed Underpayment is collected for the year in which the audit is completed (the “Adjustment Year”), rather than for the year subject to the audit (the “Reviewed Year”).
- As a result, the economic burden of the Imputed Underpayment shifts from those persons who were partners in the Reviewed Year to those who are partners in the Adjustment Year.
- If partners during the Reviewed Year are no longer partners as of the Adjustment Year, the current Adjustment Year partners may bear a tax liability that would have been borne by former partners, had the tax return originally been submitted with the changes imposed on audit.
Requiring Reviewed Year Partners to Amend Their Returns: The Act’s audit procedures permit partnerships to make an election to push out the Imputed Underpayment from the partnership in the Adjustment Year to the partners as of the Reviewed Year (the “Push-Out Election”).
- If partnership makes the Push-Out Election, the partners for the Reviewed Year, rather than the Adjustment Year, will be liable for the Imputed Underpayment (although the Imputed Underpayment is still determined at the partnership level).
- If the Push-Out Election is made, interest will be imputed at the federal short-term rate plus 5 percentage points, so the Reviewed Year partners are in effect subject to a penalty.
- The partnership must provide the Reviewed Year partners with a statement of each partner’s share of any adjustment to income, gain, loss, deduction, or credit as determined in the notice of final partnership adjustment.
Electing Out: Certain partnerships may elect out of the new audit procedures.
- Generally, a partnership with 100 or fewer partners may elect out, but only if each of its partners is an individual, estate, or corporation (including certain types of foreign entities).
- If a partner is an S corporation, all owners of the S corporation are counted when determining whether the 100 or fewer partner threshold is met.
- Partnerships with partners that themselves are partnerships (multi-level partnerships) cannot opt out.
- Partnerships with partners that are revocable trusts or single member LLCs taxed as disregarded entities cannot opt out, under current IRS guidance.
- The election must be made each year, with a timely filed return for the partnership and disclosing the name and taxpayer identification number of each partner.
RESPONDING TO THE CHANGES
The above is only a brief overview. The IRS has issued proposed regulations, but they do not cover everything and further guidance is expected. However, because the rules will apply at the start of next year, it is necessary to begin preparing for them now.
Items to consider include the following:
- Should the partnership agreement (or operating agreement for an LLC) include provisions to address potential tax liabilities from prior years that may not be discovered until years later on audit, such as:
- requiring indemnification from former partners?
- escrowing final distributions from departing partners until the risk of a Reviewed Year audit has passed?
- establishing an annual tax reserve fund?
- If the partnership is eligible to elect out of the Act’s audit procedures, should the partnership agreement be drafted to:
- require the partnership to elect out?
- permit the election upon some vote of the partners?
- prohibit electing out?
- If the partners anticipate wanting to elect out, should the partnership agreement be drafted to ensure the partnership is eligible to elect out, including:
- limiting the number of permitted partners to stay below 100?
- prohibiting partners that themselves are tax partnerships (e.g., general partnerships, limited partnerships, or multi-member LLCs taxed as partnerships)?
- prohibiting partners that are revocable trusts or single member LLCs taxed as disregarded entities?
- How will the initial and successor partnership representatives be chosen? Should there be provisions for removing the partnership representative?
- Should the partnership agreement require the partnership representative to provide partners notice or other rights about audits? What about former partners who were partners during a Reviewed Year?
- Should there be special indemnification provisions for the partnership representative?
- If a partner transfers his or her interest, who should be liable for any potential Adjustment Year tax attributable to the transferred interest for years before the transfer? The transferring partner, the transferee, or both?
If you have an ownership in or are otherwise involved with any entity taxed as a partnership, you should discuss with your tax advisor how the entity will respond to the new rules. This may include amending your current partnership or operating agreement.
DISCLAIMER: The information provided is for general informational purposes only. This post is not updated to account for changes in the law and should not be considered tax or legal advice. This article is not intended to create an attorney-client relationship. You should consult with legal and/or financial advisors for legal and tax advice tailored to your specific circumstances.