February 5, 2018
New Streamlined IRS Partnership Audit Rules
Implementation of the Tax Cuts and Jobs Act, coupled with a recent government shutdown, can make it difficult to stay informed on new legislative changes that may impact you. This can be especially true for legislation passed in 2015 but not effective until tax years beginning after December 31, 2017. For this reason, we wanted to highlight the new partnership audit rules, to be effective for tax years beginning after December 31, 2017, that were passed in the Bipartisan Budget Act of 2015 (commonly referred to as BBA).
Old Partnership Audit Rules
Before we begin to highlight the new partnership audit rules a brief explanation of the previous rules is necessary to highlight the changes. A partnership is a pass-through entity where all partnership items of income, gain, loss, deduction, or credit are passed-through to the partners and reported on their returns. Therefore, when a partnership was audited, and an adjustment was determined, the IRS would generally recalculate the tax liability for each partner. The partner would then have to pay any assessed taxes, interest and penalties.
New Partnership Audit Rules
Under the new partnership audit rules, subject to exceptions, when a partnership is audited, any resulting audit adjustment/tax liability is not recalculated for each partner. Rather, the adjustment is assessed and the related tax is collected at the partnership level. Therefore, the partnership, as opposed to the partners, would be required to pay any assessed taxes, interest and penalties.
Determination of Tax
Typically, a partnership does not pay tax. Therefore, the new rules provide procedures on how the tax will be assessed at the partnership level. The tax due will be determined by multiplying the net of all the audit adjustments for the year under examination by the highest individual or corporate Federal income tax rate. This could lead to partners bearing the burden of a tax in a year they were not a partner. For example, if a partnership was audited for its 2018 tax return and an audit adjustment was assessed by the IRS in 2019, then any new partners that were admitted in 2019 would bear the burden of the assessment for a year they were not a partner, because the partnership would be liable for the 2018 assessment in 2019.
To alleviate this issue, an election was put into the legislation to apply the assessment to the partners who were in the partnership during the audit year. Commonly referred to as the “Push-Out” election, the partnership would provide adjusted information returns to the partners during the audit year and those partners would calculate the additional tax for the audit year but make the payment in the year they receive the adjusted information return from the partnership. The “Push-Out” election is made within 45 days of a notice of final adjustment from the IRS. Therefore, prompt attention to this election is needed by the partnership representative.
Partnerships may want to consider making amendments to their partnership agreements to determine how they would deal with this potential tax upon an audit. A “Push-Out” election provision may make sense but might require some record keeping by the partnership to be able to potentially provide the adjusted information returns to former partners.
The new partnership audit rules remove the tax matters partner and replace it with a partnership representative. The partnership representative has the authority to act on behalf of the partnership for an audit (and other Federal tax matters). This representative may be an entity, although an individual will need to be appointed on the entity’s behalf. The new rules provide that the representative has sole authority to act on behalf of the partnership, including all the partners, for matters including, but not limited to, agreeing to settlements, extending the statute of limitations, and agreeing to a notice of final partnership adjustment. Therefore, extra care will need to be taken when determining who the partnership representative will be.
Application of New Partnership Audit Rules
The new partnership audit rules apply to all partnerships, but, starting in 2018, a partnership that is considered small may make an annual election with their tax returns to elect out of the new rules. This election essentially requires the audit to be performed as if it was an audit of an individual tax return (similar to the old rules). The election to qualify as a small partnership is available if:
The partnership has less than 100 partners and each partner is one of the following
b. C Corporation (Including RIC & REIT)
c. Foreign entity treated as a C Corporation under U.S. rules
d. S Corporation
e. Estate of a deceased partner
A partnership is considered to have a 100 or fewer partners when it is required to furnish 100 or fewer Schedule K-1’s but special rules apply to determine indirect partners. If one of the partners is an S Corporation than the number of shareholders in that S Corporation are considered when calculating 100 or fewer partners. For example, if a partnership has 80 partners but one of those partners is an S Corporation with 30 shareholders than the total count for the 100 or fewer partner test is 109 (79 partners plus 30 S Corporation shareholders). In that example the partnership would not be considered small to make the annual election with their tax return to elect out of the new rules.
Therefore, the new partnership rules automatically apply to the following:
A partnership with more than 100 partners or
A partnership with less than 100 partners but any partner is a
b. Trust (including grantor)
c. Foreign entity (unless specifically exempt)
d. Disregarded entity (ex. SMLLC)
e. Nominee (holds the interest on behalf of another person)
f. Estate of an individual other than a deceased partner