NEW PARTNERSHIP AUDIT RULES
Beginning 2017, partnerships are subject to new IRS audit rules as a result of the Bipartisan Budget Act of 2015. Owners of partnerships/LLCs should review these new audit rules and consult with their attorneys to update their operating agreements.
a. Partnerships were audited at the partner level and not the partnership level because partnership net income was reported by and paid by the individual partners and not the partnership directly, unless an election was made by the partnership.
b. If there were adjustments to a partnership return because of an IRS audit, the partners were then responsible to update their individual returns and address any underpayment.
c. However, partnerships with more than 10 partners were audited under the “TEFRA” procedures in which the IRS audits a partnership and passes on assessments to each individual partner who was a partner for the reviewed year.
II. New Rules
a. These new procedures are effective for taxable years beginning January 1, 2018.
b. Generally, the new rules require audit adjustment of all items of income, gain, loss, deduction, or credit at the partnership level, with the partnership liable for any resulting underpayment of tax.
c. Additional taxes, as well as penalties and interest, arising from an audit are payable by the partnership. The adjustment is referred to as an “imputed underpayment” amount.
d. If the IRS determines there is an imputed underpayment, the amount is generally calculated by netting all adjustments for the reviewed year and multiplying the net amount by the “highest rate of tax in effect for the reviewed year under section 1 or 11” (i.e., the highest individual or corporate rate).
e. There are three problems with this approach:
i. Individual partners may not be taxable at the highest rate;
ii. The partnership ends up paying the partner’s tax liability; and,
iii. Partners in the tax year may no longer be partners when there is an audit.
III. Alternatives to having the partnership pay the underpayment include:
a. Small partnership elect out
i. Audits will be conducted on the individual partner level.
ii. The election must be made annually.
iii. A small partnership is defined under the Act as having:
1. No more than 100 partners;
2. Can only have individuals, corporations, S corporations, foreign entities taxable as a C corporations and estates are eligible partners for this test; and,
3. Meaning if one of the partners is another partnership, the partnership is not eligible to elect out.
b. Push Out/Pass through election
i. Audit adjustments taken into account by the partners who were partners during the reviewed year.
ii. Each partner is required to include the audit adjustments in the year in which the audit concludes (i.e. not an amended return).
iii. A partnership may elect:
1. Within 45 days after notice of adjustment
2. To furnish each partner in the reviewed year a statement of the partner’s share of the adjustment,
3. Who are then responsible for reporting the adjustment in the year of the review (meaning not amending a prior year return but reporting the adjustment in the current year), and
4. The payment of the tax in the year of adjustment.
iv. If the push-out election is made, the applicable underpayment interest rate is increased by two percent.
c. Amended K-1s for partners
i. A partnership may elect to issue amended K-1s to each partner, who was a partner for the reviewed year, incorporating the partnership audit adjustments.
1. If a partner files an amended tax return and
2. Pays the taxes within 270 days of the partnership receiving notice of a proposed partnership adjustment, then
3. Such amount would be deducted from the amount the partnership owes at the entity level.
IV. Partnership Representative.
a. Tax matters partner is replaced with a “partnership representative” under the Act. The partnership representative:
i. Has exclusive authority to represent the partnership in an IRS audit.
ii. Does not have to actually be a partner in the partnership.
iii. Is required to have a “substantial presence” in the United States.
iv. Has more power than the tax matters partner and can bind partners to a settlement with the IRS without their input or consent.
V. Other provisions of the new law
a. No statutory requirement under the new rules to notify partners that an audit has commenced.
b. Partners have no statutory rights to participate in a partnership audit.
c. Certain partnerships are eligible to apply new audit rules prior to January 1, 2018.
VI. Potential adjustments to partnership/LLC agreements
a. Permit the partnership to pay the tax
i. This may require partners to make contributions; or,
iii. Take on debt.
b. Determine Push Out Adjustment in case of audit (effects the current partners), or
c. Determine if Amended returns would be filed by partners/partnership (partners of the reviewed year effected).
d. Require the partnership representative to provide notice to the partners regarding any material tax audits.
e. Require the partnership representative to consult with the partners during the course of an audit.
We can work with partnerships and their counsel to amend partnership/LLC agreements to adjust to these new tax rules.
Maloney & Kennedy, PLLC