In 2015, Congress repealed and replaced the existing partnership tax audit regime with a new set of rules which are generally in effect for tax years beginning after 2017. The old rules, commonly referred to as the TEFRA rules, since they were enacted by the Tax Equity and Fiscal Responsibility Act of 1982, were replaced when Congress enacted the Bipartisan Budget Act of 2015 (“BBA”). The BBA audit regime details the new partnership tax audit rules that, in summary, assesses and collects taxes due because of an audit at the entity level instead of at the partner level.
The New Partnership Audit Rules are generally effective for tax years beginning after 2017. The new rules will allow for a centralized audit system whereby partnership adjustments will be determined at the partnership level and any tax attributable to the adjustments will be assessed and collected at the partnership level. Under the old rules the IRS would conduct audits at the partnership level but then assess each partner of the partnership for the audited year for their related share of adjusted items. As discussed later, partnerships with 100 or fewer partners can annually elect out of these new rules.
The new rules, while more efficient for the IRS, could create an unfair assessment of tax on a partner by partner basis. Because the partnership itself is liable for the adjustments made at the partnership level under the default rule, partners responsible for the additional tax owed by the partnership may not be the partners to which the liability actually relates. If there is a change in the partners’ ownership percentages or the removal or addition of partners from the year under audit to the date the audit is finalized, the old partner percentages will not automatically be taken into consideration. For example, newly admitted partners could be paying a tax liability that originated from retired partners.
The default under the new rules to tax the partnership and not the partners themselves is further complicated by the timing of the assessment. The tax year under audit, (the review year), will be different from the year in which the assessment becomes final and made payable to the IRS, (the adjustment year). If the partners’ ownership is not consistent between the review year and the adjustment year there will be a disconnect between the partners to which the liability relates to and the partners which are paying for that same liability. One way to avoid this unfair assessment of tax on a partner by partner basis is for the partnership to elect to “push out” the partnership level audit adjustments to its partners for the reviewed year. Several items should be considered before making the Push-Out Election, including, but not limited to, the impact to each review year partner versus each adjustment year partner, the fact that the election is irrevocable and must be made within 45 days of receiving a Final Partnership Adjustment notice from the IRS, and, finally, the 2% interest assessed at the partnership level as imputed underpayment in exchange for making this election.
The imputed underpayment will be calculated by the IRS and provided to the taxpayer on a notice of proposed partnership adjustment. The entity level tax computed will take into consideration the total net positive partnership adjustments multiplied by the maximum income tax rate allowable for the reviewed year. There are certain modifications available to the taxpayer if the imputed underpayment amount is higher than the amount due had the partnership and partners originally reported the adjustments correctly. Modifications that may be requested include the application of lower tax rates, filing amended returns or partners using the “pull-in procedure” which allows for partners to take into account their allocable share of partnership adjustments and pay the taxes due. There is an administrative cost to the pull-in procedure as it requires that substantiating documentation be provided to the IRS showing proper computation, inclusion and payment of taxes due by each partner. The elections made and modifications requested are done at the partnership level and require a designated person in place to make decisions during the audit of how the partnership will handle these matters.
The New Partnership Tax Audit Rules also require each partnership to designate a Partnership Representative. The designated representative will have the sole authority to act on behalf of the partnership with respect to an audit of the partnership. If the partnership does not designate a representative the IRS will appoint one on their behalf. Whether chosen by the partners or the IRS, the partnership and all of its partners will be bound by the actions taken and decisions made related to the audit by the Partnership Representative.
Any partnership (domestic or foreign) required to file a partnership return in the United States is subject to the new rules unless they meet the Small Partnership Exception. The Small Partnership Exception allows for certain partnerships with 100 or fewer partners for the tax year, (measured by the number of K-1s issued during the year), to opt out of the new centralized audit regime. The election must be made annually with a timely filed return and requires that certain disclosures accompany the election.
If your partnership has not addressed the New Partnership Tax Rules then now is the time to do so. Certain precautionary measures can be taken to ensure that your partners are aware of the new changes and can agree on how they want to handle any future audits. Amending your partnership agreement to address who the designated Partnership Representative will be and what the partners’ rights will be with respect to audit notification, participation and input on elections made or settlements reached is a key point to address before an audit arises.
Please contact your Citrin Cooperman adviser or a member of our Federal Tax Policy Team to discuss how the New Partnership Audit Rules apply to you and how you can prepare for future audits.