Federal audits of partnership 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 audit rules each year.
While this may be the most favorable option, it has fairly limited application, since it requires the partnership to (a) have 100 or fewer partners and (b) have only partners that are individuals, C or S corporations, foreign entities that would be treated as C corporations if they were domestic entities, or estates of deceased individuals. Thus, a partnership that has a partner that is a trust, another partnership, a foreign entity that would not be treated as a C corporation if it were domestic, or a disregarded entity (a single-member LLC, a qualified Subchapter S subsidiary, or a grantor trust) cannot elect out. The “100 or fewer” test is generally based on the number of K-1s that are issued by the partnership that year. However, a partnership that has an S-corporation partner is required to count not only the K-1 issued to that S corporation, but also the number of K-1s that S corporation issues to its shareholders.
This is an annual election, made on a timely filed tax return (including extensions), that can be revoked only with IRS consent, so the decision to elect out should be made only after careful consideration of the implications. In addition to checking a box on its return, the partnership is required to include in the return a statement that provides specified information about each of its partners. If the partnership making the election has a partner that is an S corporation, the partnership must also provide this same specified information about each of the shareholders in that S corporation. In addition, a partnership that makes the election out is required to notify each of its partners that the election has been made.
- Allow the default rules to apply.
Under the new default rules, the partnership entity is required to pay any IRS audit assessment, including tax, penalties, and interest. Unless certain specifically allowed modifications are made, the tax liability owed by the partnership will be calculated at the highest individual or corporate tax rate in effect for the year being audited. This option causes those who are partners in the year the tax is paid to bear the burden of such payment, rather than those who were partners in the tax year(s) under audit. Audits that do not result in additional amounts due to the IRS will be treated as adjustments to amounts reported to the partners in the year in which the audit is completed, again impacting the current partners rather than those who were partners in the year under audit. Guidance from the IRS provides several opportunities for the partnership to reduce its imputed tax liability under these default rules.
- Push the tax liability out to partners.
The audited partnership can elect to push the audit adjustments to those partners in the year under audit. The partners will then report the additional income and pay the additional taxes through a simplified amended return process. While this option results in the “correct” partners bearing the results of the audit (those who were partners in the year under review, rather than the current partners), the price paid for utilizing this option is that interest will be assessed on those partners at a rate that is two percent higher than if the partnership itself had paid the tax. Unlike the “opt out” election, which must be made each year with the partnership’s income tax return, this election does not need to be made until 45 days after the final partnership adjustment (FPA) resulting from the audit is mailed to the partnership by the IRS.
It is essential that partnerships immediately start to understand and evaluate the impact of these new audit rules, as well as consider the decisions and actions they may need or want to take now to protect the partnership and/or its partners.
The first step is to identify the “partnership representative” who, under the new centralized audit rules, is the person with broad, exclusive authority to act on behalf of the partnership and all of its partners with respect to partnership items under audit. Note that appointment of a partnership representative is not required if the partnership elects out of these new rules, but it is recommended. This representative has far greater power — and also greater risk — than the “tax matters partner” under the TEFRA audit rules. In addition, the following considerations need to be made:
- Revisions to the partnership agreement
- Revisions to documents where tax disclosures are required (e.g., private placement memorandums)
- Additional due diligence and documentation on the acquisition or sale of existing partnership interests and on mergers involving partnerships to avoid the shifting of tax burden to the “wrong” partners
- Analysis of the impact of these federal audit changes on state tax audits and liability
For more information regarding the impact of these changes and elections, as well as assistance in making any corresponding changes to your partnership documents, please contact your Wipfli relationship executive.