On September 8, 2023 the IRS announced a sweeping effort to focus enforcement efforts on high-income individuals, partnerships, and corporations. On September 20, 2023 the IRS announced that it will establish a special passthrough organization to help audit initiatives for high-income individuals and complex partnerships. Government officials have signaled that internal briefings are starting for current IRS examiners on the initiative and that training will almost certainly be given to additional 3,700 nationwide new employees the IRS intends to hire. High-income taxpayers (i.e. those making more than $400,000 a year) and partnerships are on notice that the IRS is coming. If you are in the target group, are you ready for increased IRS scrutiny?
In general, the IRS has three years to make an assessment from the filing of the tax return. If you never file a return, then the statute remains open. Therefore, assuming timely filed returns, the last three years should be considered and any large transactions or unique investments will likely be given increased scrutiny. At the IRS, paper is king. Therefore, it is worth the effort to review financial transactions and tax returns and make sure you have supporting documentation for those activities. Corporations and partnership are likely to have better recordkeeping policies. However, it would benefit them to also review those policies and make sure they are being complied with for when audit notices and their subsequent Information Document Requests (IDRs) show up.
The focus on partnerships comes with the backdrop that the Bipartisan Budget Act (BBA) was signed into law by President Barack Obama in 2015 and fundamentally changed the way partnerships are audited. Under the BBA, the IRS generally assesses and collects any understatement of tax (called an imputed underpayment) at the partnership level. The new rules were applicable to all entities starting on January 1, 2018, unless they are eligible to elect out. Tax advisors are almost uniform in their guidance that if a partnership can elect out of the new rules they should do so. This election must be made each year on the original IRS Form 1065 and, unless revoked or invalid, puts the partnership under general deficiency audit procedures. In general, partnerships with 100 or fewer partners for the taxable year can elect out of the BBA audit rules if all partners are eligible partners. Ineligible partners include partnerships, trusts, foreign entities that would not be treated as a C corporation were it a domestic entity, disregarded entities, estates of individuals other than deceased partners and, people who hold an interest in the partnership on behalf of another person. Partnerships should review their structure to see if election out of the BBA rules is possible and, if not, if changes are worth making to elect out in future years.
Also important is the designation of the Partnership Representative (PR), which must be designated each year on the tax return. The Partnership Representative (PR) as the sole person the IRS will contact and deal with during the audit. Partners must consider the PR designation carefully to ensure the proper person will be communicating exclusively with the IRS. If the partnership receives an audit notice, it may want to change the person previously designated so the right person is communicating with the IRS. However, there are specific deadlines and procedures to make that change of representative effective.
What happens if you notice an error that needs correction? The answer before the BBA audit rules was filing an amended return, now any corrections to a partnership’s tax return must be made as an Administrative Adjustment Request (AAR), which can only be filed by the Partnership Representative. Any AAR must calculate whether the requested adjustments result in an imputed underpayment (IU) and, if so, must report that IU. The IU must be paid by the partnership or “pushed out” to partners who calculate, report and pay the corresponding amounts. Therefore, any change to correct a mistake or to benefit the partnership must also consider the potential impact if audited. Partnerships are a popular and flexible choice for taxpayers to use in operating their businesses. However, they come with their own unique challenges when complying with the tax laws and specific audit rules for partnerships (i.e. BBA). The start of an audit is an unfortunate time to realize certain challenges weren’t considered. A review of current partnership agreement terms will help ensure proper protections are in place if audited. Considering the tax impact of changes in the partnership, as they occur, will also help keep a partnership ready for the new wave of audits the IRS is planning.