The Bipartisan Budget Act of 2015 (129 Stat. 584, Public Law 114–74, Nov. 2, 2015, H.R. 1314) (the “Act”) contains a new partnership audit regime the implementation of which will begin for audits of partnership tax returns for years beginning on or after January 1, 2018. Even though such audits may not occur until years after the January 1 date, partners and their partnerships, ought to begin immediately to consider amendment of partnership agreements to reflect the new audit regime.
Three different regimes currently exist for auditing partnerships. 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 most large partnerships with more than 10 partners, the IRS conducts a single administrative proceeding (under the so-called “TEFRA” rules, which were adopted as part of the Tax Equity and Fiscal Responsibility Act of 1982) to resolve audit issues regarding partnership items that are more appropriately determined at the partnership level than at the partner level. Under the TEFRA rules, once the audit is completed and the resulting adjustments are determined, the IRS must recalculate the tax liability of each partner in the partnership for the particular audit year. A third audit regime applies to partnerships with 100 or more partners that elect to be treated as Electing Large Partnerships (“ELP”) for reporting and audit purposes. A distinguishing feature of the ELP audit rules is that unlike the TEFRA partnership audit rules, 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).
Under Sec. 1101 of the Act, the current TEFRA and ELP rules would be repealed, and the partnership audit rules would be streamlined into a single set of rules for auditing partnerships and their partners at the partnership level.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 provision would permit 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. Under the streamlined audit approach, the IRS would examine the partnership’s items of income, gain, loss, deduction, credit and partners’ distributive shares for a particular year of the partnership (the “reviewed year”). Any adjustments would be taken into account by the partnership (not the individual partners) in the year that the audit or any judicial review is completed (the “adjustment year”). Partners would not be subject to joint and several liability for any liability determined at the partnership level. Partnerships would have the option of demonstrating that the adjustment would be lower if it were based on certain partner-level information from the reviewed year rather than imputed amounts determined solely on the partnership’s information in such year. This information could include amended returns of partners opting to file, the tax rates applicable to specific types of partners (e.g., individuals, corporations, tax-exempt organizations), and the type of income subject to the adjustment (e.g., ordinary income, dividends, capital gains). As an alternative to taking the adjustment into account at the partnership level, a partnership would be permitted to issue adjusted information returns (i.e., adjusted Form K-1s) to the reviewed year partners, in which case those partners would take the adjustment into account on their individual returns in the adjustment year through a simplified amended-return process. As a result, partnerships generally would no longer issue amended Form K-1s after the partnership return is filed, but instead would use the adjusted Form K-1 process. A partnership would also have the option of initiating an adjustment for a reviewed year, such as when it believes additional payment is due or an overpayment was made, with the adjustment taken into account in the adjustment year. The partnership generally would be permitted to take the adjustment into account at the partnership level or issue adjusted information returns to each reviewed-year partner. The provision applies to returns filed for partnership tax years beginning after 2017.
The new audit regime could impact partnerships in which any change of ownership occurs between the year being audited (liability arises as of the time of the audit) and the year of assessment, making purchasers responsible for a prior year’s audit and tax deficiency. The IRS will, therefore, effectively collect from those partners existing at the time of assessment without regard to any partnership agreement between the partners. As outlined above, an audit will result in the partnership, not the partners, being responsible for any tax deficiency, associated interest, and penalties assessed against the partnership. Any deficiency is to be computed at the highest individual income tax rate, but the partnership may initiate adjustments based on the nature of the income recognized in the audit and the tax status of the partner, e.g. corporate, individual, etc.
There is a process available pursuant to which a partnership may elect to charge any tax deficiency to partners existing in the audit year. However, such an election is subject to IRS approval based upon certain criteria.
Some additional points for consideration:
Some guidance exists on the application of the audit rules. Regulations previously stalled due to the moratorium on new regulations were republished in proposed form and the comment period ended on August 14, 2017.
LLCs which have not indicated to the contrary are subject to the partnership rules and advisors should consider routinely filing Form 8832 “Entity Classification Election” to avoid any misunderstanding as to the entity’s tax status.
If able to pass two tests, partnerships may elect out of the new audit regime, but consideration should be given to the amendment of a partnership agreement to address a possible failure of the election.
The new audit regime introduces the status of “partnership representative,” (which need not be a partner) which is not synonymous with a “tax matters partner” under TEFRA and provides for such person’s authority. Partners ought to carefully weigh who ought to be the partnership representative and affirmatively select the same rather than relying on the IRS to do so.
When considering a partnership’s election to treat partners in existence in the audit year as responsible for any deficiency of the partnership, assessed at the entity level, the partnership representative ought to keep those partners apprised of what their responsibility might be if the representative decides to make such an election, as that authority rests with such person. Clearly, that person’s role vis-à-vis the partners must be addressed in the partnership agreement. The IRS, however, has no interest in the same.
There have been reports of calls for delaying the January 1 date for implementation of the new audit regime. However, the new rules make the job of the IRS easier and are anticipated to increase revenue from partnership audits so that delay may be unlikely.
In spite of many unanswered questions revolving around the new audit regime and a possible delay in its implementation, advisors and partners ought to look to the amendment of partnership agreements now in order to, at the very least, name a partnership representative and set forth the parameters of the authority of such person between the partners. January 1, 2018 is not far off.