New Audit Guidelines for Partnerships

The Bipartisan Budget Act of 2015 (the Budget Act) includes major changes in the way the IRS will audit entities that are classified as partnerships for federal income tax purposes.  In general the Budget Act repeals current-law audit and adjustment procedures for partnerships (commonly referred to as TEFRA) and rules for electing large partnerships (ELP) and replaces them with a centralized system for the audit, adjustment, assessment, and collection of tax applicable to all partnerships other than eligible partnerships that elect out.  This includes any adjustments to items of “income, gain, loss, deduction, or credit.”  Those partnerships audited under this new regime will have taxes, interest and penalties assessed and collected directly at the entity level, from the partnership itself at the time of the audit, unless the partnership elects to pass the adjustment through to its partners.

Mandatory implementation of this new audit regime begins for audits of partnership tax years starting ON OR AFTER JANUARY 1, 2018. 

A summary of the main points of the new audit regime are as follows:

APPLICABILITY OF NEW RULES

There are an estimated 1 million-plus partners under the U.S. tax system.  In 2014, more than 99.7 percent of partnerships had fewer than 100 partners (and nearly 94.4 percent of partnerships had fewer than 10 partners.)  The new audit and adjustment rules generally apply to all partnerships.  However, consistent with the statute, a partnership may elect out of the new regime if it meets two conditions.  First, a partnership must have 100 or fewer partners.  Second, a partnership must have only “eligible partners” which according to the statute include C corporations, foreign entities that would be treated as a C corporation if they were domestic, S corporations (even if one of its shareholders is not), and estates of deceased partners.  If an eligible partner is an S corporation, the number of shareholders would add to the total count of eligible partners for the partnership.  For example, if a partnership had 95 eligible partners including an S corporation and that S corporation had 6 shareholders, then the partnership would be considered to have 101 “eligible partners” according to the new audit rules.  Also unlike TEFRA, a husband and wife are not treated as a single partner for these purposes.

Regarding tiered partnership structures, the regulations would not expand the definition of “eligible partner” to include a disregarded entity.  Also the term “eligible partner” does not include partnerships, trusts, foreign entities that are not eligible foreign entities, and estates that are not estates of a deceased partner.

The election to opt out of the new partnership audit regime would be made on a timely-filed partnership return (including extensions) for the tax year to which the election relates.  The partnership would have to disclose to the IRS the names, correct TINs and federal tax classifications of all partners and all shareholders of a partner that is an S corporation.  In addition, a partnership electing out of the regime must notify each of its partners of the election within 30 days.

Issues

There is little or no guidance from the IRS about tiered structured partnerships, particularly lower-tiered partnerships.  As the statute stands, lower-tiered partnerships will not be eligible to opt out of the new audit regime because they have partnerships as partners and therefore cannot make the 100-or-fewer partners election.

TAX ASSESSED AND COLLECTED FROM PARTNERSHIP

Any tax attributable to items of income, gain, loss, deduction, or credit of the partnership is generally assessed and collected at the partnership level (not the partner level).  This partnership-level tax is assessed and collected in the same manner as if it were imposed in the “adjustment year” (generally, the year the notice of the final partnership adjustment is mailed unless the partnership disputes the adjustment in court).

The tax then payable by the partnership, which is called an “imputed underpayment,” is calculated by netting the adjustments to the income and loss items of the partnership and multiplying the amount by the highest individual or corporate tax rate for the reviewed year.

As an alternative to the partnership’s paying the tax assessed on the imputed underpayment, a partnership may elect to pass the adjustment through to its partners or what is termed a “push-out” election.  This election must happen no later than 45 days after the date of the notice of final partnership adjustment by the IRS.  Under this alternative, the partnership furnishes the IRS and each reviewed-year partner with a statement of the partner’s share of any adjustment to income, gain, loss, deduction, and credit as determined in the notice of final partner adjustment.  THIS TAX IS IMPOSED AS A TAX FOR THE CURRENT YEAR, NOT THE REVIEWED YEAR.  The partner’s increase in tax equals the aggregate of the “adjustment amounts” which include the additional tax that would have been due in the year under review and any intervening year as if the adjustment had been taken into account by the partner on his or her return for the reviewed year and all subsequent returns up to and including the current-year return.  Interest is determined at the partner level, computed at a rate that is two percent higher than the normal rate applicable to underpayments.  Penalties are still determined at the partnership level, but reviewed-year partners are liable for such amounts.

Issues

Once again, there is little or no guidance from the IRS about tiered structured partnerships and how they relate to passing the adjustments out to partners. It is not clear how it would work if an upper-tiered partnership received a statement from a lower-tiered partnership to pay the taxes from the reviewed year.  It would seem logical that any taxes or adjustments would flow from the lower-tiered partnerships through the upper-tiered partnerships and out to the partners, there is nothing in the regulations to give guidance to this.

The push-out election also exacerbates due process concerns in that it results in personal liability for adjustment-year partners who may not have even been aware of the proceedings, much less had any opportunity to participate in them.  The partnership is liable for the imputed underpayments, and liability is shifted to reviewed-year partners only as a consequence of their voluntary agreement to indemnify the partnership or file amended returns.  Hypothetically therefore, new partners to the partnership may have to take on an added tax burden during the adjustment year that was brought upon partners no longer in the partnership, but were partners during the review year.  A review of the audit procedures contained in partnership agreements should take place as soon as possible to attempt to avoid any unfair allocation of audit adjustments.

PARTNERSHIP REPRESENTATIVE

The repeal of TEFRA means that under the new partnership audit regime there will no longer be a tax matters partner.  The new regime would require a partnership to designate an eligible partnership representative that has the sole authority to act on behalf of the partnership.  The partnership representative may be any person, including an entity, and need not be a partner.  If an entity is designated, however, the partnership must also appoint and identify an individual to act on the entity’s behalf.  The partnership must have substantial presence in the US – generally meaning that the representative is able to meet or speak with the IRS at a reasonable time or place, be reachable during normal business hours at a US address and have a phone number with a US area code, and have a US Taxpayer Identification Number.

IF THE PARTNERSHIP FAILS TO DESIGNATE A PARTNERSHIP REPRESENTATIVE, THEN THE IRS WILL DO SO IN THE EVENT OF AN AUDIT.  The IRS must send notice of proceedings and adjustments to the partnership and the partnership representative, but has no obligation to provide notice to individual partners.  Partners have no statutory rights individually to initiate or participate in administrative or judicial proceedings (including settlement conferences and claims for refunds), or even to be kept informed of such proceedings by the partnership representative.

Issues

The choice of partnership representative will be a crucial one that should not be taken lightly because of the broad powers given.  As each partnership is different, different factors could affect the decision as to who would become the partnership representative.  An existing partner may be accused of self-interest, while a non-partner, an independent advisory firm, for example, may find itself in the middle of political infighting.

There has been a slow response from the Internal Revenue Service to issue much needed guidance probably due to the freeze on new regulations as a part of a review by the Trump administration of all pending regulations packages by new department or agency heads.  Audits of tax years starting in 2018 are not likely until well into 2020 at the earliest, so partners and partnerships have been slow in preparing for these changes.  A partnership will also not wish to wait until an audit begins to have to think about adjustment allocations or partnership representatives, nor allow the IRS to make the choices for the partnership, so it is imperative to have a conversation with your HLB Gross Collins, P.C. representative and consider amending partnership agreements as soon as possible.

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