New IRS Tax Audit Rules for Partnerships
The Bipartisan Budget Act of 2015 (“Act”) made significant changes to the Internal Revenue Service’s (“IRS”) partnership audit rules effective for partnership tax years beginning in 2018. How the new audit rules will affect a partnership and its partners will depend, in large part, on choices the partnership, the partnership representative, and/or the partners make or fail to make.
The new partnership audit rules are complex. Consequently, the information contained in this letter is general in nature and is not intended to address all the nuances in the new rules that may impact your partnership.
What are some of the significant highlights of the new partnership audit rules?
Under the new rules, the IRS will audit, assess and collect tax at the partnership level. If the IRS determines that additional tax is due at the conclusion of an audit, the Act allows the IRS to impose tax, interest, and penalties on the partnership at the entity level in the year of the adjustment, at the highest rate then in effect for individuals or corporations (the “default rule”). Consequently, the partnership would pay the tax directly, causing the then-current partners to indirectly pay their respective share of the tax.
However, two provisions under the “default rule” permit partnerships to reduce the tax owed at the time of the assessment. The first provision allows the partnership to provide the IRS with sufficient information regarding the individual tax attributes of the affected partners (e.g., tax exempt status, etc.) to help reduce the tax. The second provision would permit one or more partners to amend their tax returns for the year under examination taking into account all adjustments properly allocable to such partners, and pay tax due with their amended returns.
Alternatively, the Act does have the following provisions to allow certain partnerships the ability to elect out of the new rules.
- Small partnerships (100 or fewer eligible partners) may choose to “opt out” of the new partnership audit rules by making an annual election on a timely filed Form 1065 for the applicable tax year. This option is not available to any partnership that itself has partners that are also partnerships (including LLCs taxed as partnerships).
- Another option, the “push out” election, is available to partnerships once a notice of final partnership adjustment is issued. The partnership would need to make a timely election within 45 days of receiving a notice of final partnership adjustment to “push out” the assessment to the individuals that were partners during the audited tax year. However, the election comes at a cost: The rate of interest assessed on underpaid taxes rises two percentage points (i.e., 3% to 5%) if this election is utilized.
The Act also eliminated the position of “tax matters partner” and replaced the position with a “partnership representative.” The partnership representative under the new rules has a much more expansive role; the partnership representative has the sole and exclusive authority to act on behalf of the partnership and to bind all partners with respect to partnership matters subject to the partnership audit rules. This authority includes, but is not limited to, making relevant elections, representing the partnership during an audit, negotiating and agreeing (or disagreeing) to settle with the IRS, and seeking judicial review of an IRS adjustment.
What should partnerships do in response to the new audit rules?
Partnerships and their partners should consider modifying partnership agreements in light of these new audit rules. We strongly encourage you to consult with legal counsel as soon as possible to review and update, as appropriate, your partnership agreement.
Although we are not legal advisors, we do believe it is prudent for partnerships to address the following items in their partnership agreements:
- Identify the designated partnership representative and indicate the scope of discretion afforded to the partnership representative.
- Specify the manner in which the partnership will apply the new audit rules.
- Address the required cooperation and information sharing between the partnership and its partners.
Other provisions that may be beneficial to consider adding to the agreement include, but are not limited to, the following:
- Establish qualifications for the partnership representative and terms for removal of, or resignation by, the partnership representative.
- Address any restrictions regarding transfers of partnership interests to ineligible partners.
As always, please feel free to contact us if you have any questions. We are available to assist you, and to work with your legal counsel as appropriate, to address the implications of the new audit rules to your partnership and its partners.