By Mike Bodrato, CPA, JD
As part of the Bipartisan Budget Agreement of 2015, Congress made significant changes in the procedures used by the IRS to conduct partnership audits (including LLCs treated as partnerships) and their partners. Proposed regulations were issued on January 19, 2017, but prior to being released were withdrawn by executive order. New proposed regulations were issued on June 14, 2017. The new partnership audit rules repeal the current regime under the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”) and generally apply to tax years beginning after December 31, 2017.
Although eligible partnerships under the new law may elect out of these procedural rules, it is recommended that consideration be given to amending existing partnership (and LLC) agreements as well as modifying the tax audit provisions of future agreements to address these new partnership audit procedural rules.
The Prior Partnership Audit Rules
In 1982, the TEFRA dramatically shifted the focus of a partnership audit from the individual partner returns to the partnership return. This eliminated the inconsistencies that had previously plagued the process when each partner’s return was examined individually. However, any adjustments resulting from the partnership audit were passed through to the partners’ returns, requiring the collection process to remain at the partner level.
TEFRA’s approach became increasingly unmanageable as the number of large partnerships grew. Legislative and administrative adjustments to the law were made in an attempt to reduce administrative headaches and speed revenue collection. This ultimately resulted in a cumbersome, multi-tiered audit process, with different procedures applied based upon the size of the partnership.
Why are the New Partnership Audit Rules Important?
The major provisions of the partnership audit rules are important to understand because they:
- fundamentally change how tax is assessed and collected in connection with a partnership audit;
- may change the risk analysis in evaluating uncertain positions for financial reporting purposes,
- should be considered in performing due diligence work;
- require changes to new and existing partnership agreements (and LLC operating agreements), as well as other related documents (e.g., purchase and sale agreements); and
- will have state tax implications.
Major Provisions of the New Partnership Audit Rules
Some of the major provisions of the partnership audit rules include the following:
- Under the new rules, the IRS examination will be conducted at the partnership level for all partnership items of income, gain, loss, deduction or credit for a partnership taxable year. However, partners are no longer required to be notified regarding any audit developments and all partners will be bound by the determinations made by the IRS at the partnership level. Under the new regime, there will no longer be a Tax Matters Partner. Instead, the new rules require the partnership to designate a “partnership representative.” The partnership representative will no longer have to be a partner but will have broad authority to act on behalf of the partners. For this reason, the partnership representative needs to be selected with care.
- Under the new rules, if the IRS makes an audit adjustment, the partnership will generally be liable for the tax due at the entity level. This is one of the most significant changes made under the new rules to the existing procedures provided under TEFRA. It is important to note that these new rules also apply when partnership returns are amended.
- Under the new rules, the tax liability is assessed at the partnership level in the year that the audit or ultimate judicial review is completed. More specifically, the tax assessed does not relate back to the year in which the item was reported on the tax return, referred to as the “reviewed year” under the new rules. Therefore, a new partner may bear the burden of an audit assessment for years prior to the partner’s admission to the partnership.
- The partnership level tax that is assessed under these new rules is referred to as the “imputed underpayment” and is calculated by multiplying the total netted partnership audit adjustments by the highest Federal income tax rate for either individuals or corporations. Currently, this means the tax will be assessed at 37%.
- A partnership can make an election to avoid taxation at the partnership level on audit adjustments by passing the partnership audit adjustments on to the reviewed-year partners. This election to “push out” partnership audit adjustments would allow the partnership to shift the tax liability from the entity-level to the partners for the reviewed year. Those partners would be required to take the adjustments into account in the adjustment year through a simplified amended return process.
- Partnerships with 100 or less partners may elect out of the new partnership audit regime. To qualify for the opt-out election, each of the partners of the partnership must be an individual, C corporation, any foreign entity that would be treated as a C corporation if it were domestic, an S corporation, or an estate of a deceased partner. Under the new law, a partnership is not eligible to opt-out if any of its partners is:
- A partnership,
- A trust,
- Certain foreign entities,
- Disregarded entities (i.e., single-member LLCs),
- An estate of an individual other than a deceased partner, or
- Any person that holds an interest in a partnership on behalf of another partner.
The opt-out election is an annual election and must be made on a timely filed partnership tax return.
What Changes Should Be Considered?
- To address these new rules, members of existing partnerships and LLCs and those entering into new partnerships and LLCs should consider amending their existing agreements and modifying the partnership audit provisions of future agreements. Below are some considerations that may need to be addressed in response to the new partnership audit rules.
- If a partnership is eligible for making the opt-out election, consideration should be given to whether or not the partnership should opt out of the new rules. If the partnership is not eligible for the opt-out election but such election is desirable, consideration should be given to making changes to the partnership or operating agreement to make an opt-out election available.
- For those partnerships that want to opt-out of the new partnership audit regime but are not eligible for the opt-out election because of an ineligible partner (such as a disregarded entity (i.e., single-member LLC)), such partnerships should consider possible restructuring alternatives.
- Consideration should be given to restricting the transfer of interests in the partnership to ineligible partners that would preclude an opt-out election.
- Consideration should be given to making the “push-out” election in connection with an audit to have the partnership pass along the partnership level audit adjustments to the partners in order to avoid the entity-level tax.
- Consideration should be given to the extent to which partners should be entitled to notifications of partnership audit developments and the extent to which partners are permitted to influence those audits.
- Consideration should be given to the impact of the new partnership audit rules on the partnership’s financial reporting and disclosure requirements.
Mike Bodrato, CPA, is a Director of Taxes at Wiss & Company, LLP. He has over 20 years of experience in tax planning and structuring for privately held companies. For more information, contact Mike at MBodrato@wiss.com or 973-994-9400.
The information contained in this article is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your Wiss advisor.