The Bipartisan Budget Act of 2015, signed into law on November 2, 2015, raises the federal debt ceiling and lifts mandatory spending caps on defense and domestic programs. The law also includes tax provisions that revise partnership audit rules. The end result of the revised rules is that audits of master limited partnerships, investment funds, real estate partnerships, and other business entities organized as partnerships are likely to increase.
Under previous law, partnerships could be audited under three regimes:
1. Unified audit rules. Under the Tax Equity and Fiscal Responsibility Act’s (TEFRA’s) unified partnership audit rules, the tax treatment of any partnership item generally is determined at the partnership level. For most partnerships with more than 10 partners, the IRS conducts a single administrative proceeding to resolve audit issues regarding partnership items that are more appropriately determined at the partnership level than at the partner level. After the audit is completed and the resulting adjustments are determined, the IRS recalculates the tax liability of each partner in the partnership for the particular audit year.
While the single administrative proceeding can resolve an issue with respect to all partners, the IRS must still assess any resulting adjustment against each of the taxpayers who were partners in the year in which the misstatement of tax liability arose. Any partner can request an administrative adjustment or a refund for his or her own separate tax liability and participate in partnership-level administrative proceedings.
2. Small partnership rules. The unified audit rules don’t apply to any partnership having 10 or fewer partners, each of whom is an individual (other than a nonresident alien), a C corporation or an estate of a deceased partner — unless the partnership elects to have the unified audit rules apply. For such partnerships, the IRS generally applies the audit procedures for individual taxpayers, auditing the partnership and each partner separately.
3. Electing large partnership rules. Simplified audit procedures apply to large partnerships with 100 or more partners who elect to be treated as electing large partnerships for reporting and audit purposes. Under these procedures, the IRS generally makes adjustments at the partnership level that flow through to the partners for the year in which the adjustment takes effect.
The current-year partners’ shares of current-year partnership items of income, gains, losses, deductions or credits are adjusted to reflect partnership adjustments that take effect in that year. Adjustments generally won’t affect prior-year returns of any partners (except in the case of changes to any partner’s distributive shares). A partner in an electing large partnership isn’t allowed to treat partnership items on his or her return inconsistently with the partnership return, even if he or she notifies the IRS of the inconsistency.
The revised rules
Federal tax authorities have long complained that the TEFRA rules made it difficult to audit partnerships, particularly those with hundreds or thousands of members. Under the TEFRA rules, unless a partnership elects to be taxed at the entity level (which few do), the IRS must pass audit adjustments through to the ultimate partners. When hundreds or thousands of partners’ returns have to be adjusted, the costs involved sharply limit the number of audits the IRS can conduct.
The budget act repeals the current TEFRA unified partnership audit rules and the electing large partnership rules, replacing them with a streamlined single set of rules for auditing partnerships and their partners — and assessing and collecting any tax attributable to adjustments made in an audit — at the partnership level. Therefore, the changes are expected to make it easier for the IRS to audit large partnerships.
The new rules generally apply to partnership tax years that begin after December 31, 2017. However, except for the election-out rules for small partnerships, covered below, partnerships may elect (as directed by the IRS) for the changes to apply to any partnership return filed for partnership tax years beginning after November 2, 2015, and before January 1, 2018.
Under the new streamlined audit approach, any adjustment to items of income, gain, loss, deduction or credit of a partnership for a partnership tax year (and any partner’s distributive share of such adjustment) is determined at the partnership level. Similarly, any tax attributable to such adjustment is assessed and collected — and the applicability of any penalty, addition to tax or additional amount that relates to an adjustment to any such item or share is determined — at the partnership level.
The IRS will examine the partnership’s items of income, gain, loss, deduction or credit and partners’ distributive shares for a particular year of the partnership (termed the “reviewed year”), and any adjustments will be taken into account by the partnership — not the individual partners — in the “adjustment year.” What constitutes the adjustment year depends on how the adjustment was made.
Partnerships must pay tax equal to the “imputed underpayment,” which generally is the net of all adjustments for any reviewed year multiplied by the highest individual or corporate tax rate. However, the imputed underpayment may be modified if a partnership shows that a lower amount is appropriate based on certain partner-level information. The IRS will establish procedures to make such modifications where:
- A partner files an amended return for the partner’s tax year that includes the end of the reviewed year of the partnership, and that amended return takes account of the partnership adjustments and includes payment of the tax due,
- The partnership shows that a part of the imputed underpayment is allocable to a partner that wouldn’t owe tax because it’s a tax-exempt entity, or
- The partnership shows that a part of the imputed underpayment isallocable to a partner that:
- In the case of ordinary income, is a C corporation, or
- In the case of a capital gain or qualified dividend, is an individual.
Any materials required to be submitted to the IRS with respect to decreased imputed underpayments must be submitted no later than the close of the 270-day period beginning on the date on which the notice of a proposed partnership adjustment is mailed, unless this period is extended with the IRS’s consent.
Additional aspects of the revised rules include:
Partner-level adjustment alternative. As an alternative to taking the adjustment into account at the partnership level, a partnership can make an election, not later than 45 days after a notice of final partnership adjustment, to issue adjusted information returns to the reviewed-year partners. If this election is made, the partners take the adjustment into account on their individual returns in the adjustment year through a simplified amended-return process. The election must be made in the time and manner prescribed by the IRS and once made can be revoked only with the IRS’s consent.
Administrative adjustment alternative. A partnership also has the option of requesting an administrative 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 allowed to take the adjustment into account at the partnership level or issue adjusted information returns to each reviewed-year partner.
A partnership can’t file an administrative adjustment request more than three years after the later of:
- The date on which the partnership return for such year is filed, or
- The last day for filing the partnership return for that year (determined without regard to extensions).
On a partner’s return, under the “consistency requirement,” the partner must generally treat each item of income, gain, loss, deduction or credit attributable to a partnership in a manner that is consistent with the treatment of the income, gain, loss, deduction or credit on the partnership return. Small partnerships’ election out of new rules.
Similar to the TEFRA rule excluding partnerships with 10 or fewer partners, partnerships with 100 or fewer qualifying partners can elect out of the new rules for any tax year. However, this small partnership exception does not apply to a partnership in which another partnership is a member, which appears to make the exception inaccessible to any tiered partnership structure regardless of the number of ultimate partners. Is an audit in your partnership’s future?
If your company is organized as a partnership, you’ll want to take the time to familiarize yourself with the revised partnership audit rules included in the recent budget act. When they go into effect, you could be at a greater risk of being audited, and the rules are complex. The IRS is expected to issue guidance on the rules, but it’s also possible the tax agency may seek a technical correction from Congress to clarify them. Please give us a call with any questions. For more information, please do not hesitate to reach out to your Citrin Cooperman professional, or contact us at firstname.lastname@example.org.