Federal audits of partnership tax returns for tax years beginning after December 31, 2017, will be drastically different than in the past. While the old partnership audit regime (known as a TEFRA audit) resulted in the partners being liable for the tax implications resulting from an IRS audit, this new audit regime (known as a BBA or centralized audit) potentially creates an actual tax liability at the partnership level for any audit adjustments made to partnership-related items. In addition, these new rules are expected to result in a significantly greater number of IRS audits of partnerships because they are intended to simplify the audit and collection process for the IRS.
There are three general options available to an audited partnership under the new rules:
- Elect completely out of the new rules each year.
- Be completely subject to these new rules, meaning the audit is completed at the partnership level and any additional tax liability, including interest and penalties, is paid by the partnership.
- Be partially subject to these new rules, meaning the audit is completed at the partnership level, but the tax liability is pushed out to and paid by the partners.
This article will discuss the requirements, mechanics and implications of the first option, electing completely out of the new centralized audit rules each year. Other articles in this series will discuss the other two available options, as well as the appointment of the Partnership Representative to replace the Tax Matters Partner under the old TEFRA audit regime.
Do You Qualify to Elect Out?
There are two requirements that must be met before a partnership can elect out of these new rules.
The first requirement is that the partnership has only “eligible partners,” which are defined to include the following:
- C corporations
- S corporations (Note: An S corporation is an eligible partner even if it has one or more shareholders who would not be eligible partners under these rules if they held a direct interest in the partnership.)
- Foreign entities that would be treated as C corporations if they were domestic entities
- Estates of deceased individuals
Thus, this requirement will not be satisfied if the partnership has even one of the following types of partners:
- A partnership
- A trust
- A disregarded entity (e.g., a single-member LLC qualified Subchapter S subsidiary or grantor trust), even if the disregarded entity is wholly owned by an otherwise qualified partner
- A foreign entity that would not be treated as a C corporation if it were a domestic entity
- A bankruptcy estate
- A nominee or similar entity that holds an interest on behalf of another person
The second requirement is that the partnership must have 100 or fewer partners during the tax year. This “100 or fewer” test is generally based on the total number of K-1s that are issued by the partnership in the year of the election. However, a partnership that has an S-corporation partner is required to count not only the partnership K-1 issued to that S corporation, but also the number of K-1s that S corporation issues to its shareholders. There is no similar “look through” rule for partners that are estates, even if they issue multiple K-1s to the estate beneficiaries. For purposes of this “100 or fewer test,” if spouses each own separate partnership interests, they are counted as two partners. If one spouse owns a partnership interest and lives in a community property state, the other spouse is not counted as an additional partner.
The Mechanics of the Election Out
This is an annual election, which is made on the electing partnership’s timely filed tax return (including extensions) for the taxable year to which the election applies. In addition to checking a box on its return, the partnership must also disclose the following information in its return about each person who was a partner at any time during the taxable year of the election:
- U.S. taxpayer identification number (TIN)
- Federal tax classification
- Affirmative statement that the partner is an eligible partner
- If a partner is an S corporation, the same information listed above must also be disclosed for each person who was a shareholder in the S corporation partner at any time during the taxable year of the S corporation ending with or within the partnership's taxable year.
If the required information is not disclosed, that year’s election will be considered invalid.
In addition to the tax return disclosure requirements above, the partnership must also provide an annual statement to each of its partners within 30 days of making the election, notifying the partners that the partnership has made the election out of the centralized partnership audit rules. There is no specified format for this notification of partners. If the partnership has a partner that is an S corporation, the partnership is required to notify only the S corporation, not the S corporation’s shareholders. Whether and how the S-corporation partner then notifies its shareholders are left to the S corporation to determine.
Implications of the Election Out
For partnerships that elect out of the BBA audit rules, any IRS audits will be conducted at the individual partner level. Any resulting assessments will also be made at the individual partner level, governed by each partner’s statute of limitations, for the year under examination. This approach is similar to the partner-by-partner audit regime that existed prior to the TEFRA audit rules.
A partnership should consider including in its partnership agreement provisions that address how a partnership will elect out of these new rules: automatically upon signing of the partnership agreement, creating a procedure whereby the partners authorize the Partnership Representative to make the election, or giving the Partnership Representative complete discretion over when to make the election.
A partnership that intends to make this election should also consider including provisions in its partnership agreement restricting the number of partners, type of partners and ability of partners to change their tax status or transfer their interests to nonqualifying partners so the partnership remains eligible to make the election each year.
If a partnership makes a valid election out, the applicable statute of limitation for assessment of tax will be determined at the partner level and is further determined separately for each partner. If the election out is not made, the applicable statute of limitation for assessment of tax is instead determined at the partnership level.
Because the electing partnership is required to disclose the identification numbers of its partners, each of the partnership’s foreign partners must apply for and obtain a valid U.S. TIN, even if they do not have a U.S. income tax filing requirement.