Preparing for New Partnership Audit Rules
Although there are many uncertainties regarding New Partnership Audit Rules reissued by the IRS, tax partnerships and their partners are advised to review and amend their partnership agreements or limited liability company agreements to prepare for any changes effective for the 2018 tax year.
Tax partnerships are not subject to federal tax; income, loss and other tax items are allocated among partners for use in calculating their own tax liabilities. Prior to the enactments of the Tax Equity & Fiscal Responsibility Act of 1982 (TEFRA), all income tax audits of partnership items occurred at the partner level. After 1982, TEFRA audit rules went into effect with the intent to increase the efficiency of partner tax audits. For partnerships subject to the TEFRA rules, income tax audits were conducted at the partnership level and once resolved, the IRS then contacted and collected any additional tax from individual partners, not the partnership.
The IRS encountered a variety of issues under TEFRA audit rules including challenges identifying audit worthy partnerships and collecting any resulting tax liability from individual partners. To complicate matters, the number of tax partnerships were on the rise and the value of assets held through partnerships was increasing with many entities also favoring complex multi-tiered partnerships. The result: fewer audits and fewer tax deficiencies collected.
Many proposals to fix the challenges of TEFRA were made in following years, but in 2015, the Bipartisan Budget Act of 2015 was enacted to avoid a government shutdown. It also replaced existing rules for auditing large partnerships with a new set of streamlined rules that the IRS recently reissued as New Partnership Audit Rules taking effect on January 1st, 2018. Designed to address issues with partnerships with 100 or more partners, the term “eligible partner” has been defined within the rules as any person who is an individual, C-Corporation, eligible foreign entity, S-Corporation or an estate of a deceased partner. The New Partnership Audit Rules do allow smaller partnerships with 100 or fewer partners to opt out with their returns audited as part of each partner’s individual audit.
The New Partnership Audit Rules, which assess and collect tax at the partnership level, are intended to streamline challenging audit procedures faced by the Internal Revenue Service in the past. Applying to partnership tax years after December 31, 2017, the rules require that any tax due on partnership adjustments made by the IRS must be paid directly by the partnership. The partnership can then choose to collect any amount due from individual partners.
The New Partnership Audit Rules require that a partnership representative is chosen for tax matters. This representative, designated by the partnership, does not have to be a partner. It can be an individual or an entity with a designated representative. The representative is granted the sole authority to act on behalf of the partnership in tax matters under scrutiny by the Internal Revenue Service. The partner representative, not the IRS, bears the responsibility of notifying partners of IRS proceedings.
When conducting an audit, the IRS examines all income, gains, losses, deductions and credits, and partner distributions. Any tax underpayment, according to new rules, is calculated by multiplying the total netted partnership adjustment by the highest rate of federal income tax in effect for the year under review. That number is then increased or decreased by any adjustments made to the partnership’s credits. Any tax effect is at the partnership level, any penalties are determined at the partnership level and any tax assessed and collected is at the partnership level. The partnership, however, may elect to provide amended Schedule K-1’s to its partners within 45 days of the date of the notice of the final partnership adjustment. With this election, each partner becomes responsible for their share of the adjustment; which seems counter-intuitive to the new rules’ original intent.
With an effective date of January 1, 2018, The American Institute of Certified Public Accountants is urging the IRS and Treasury officials to work with Congress to revise the Bipartisan Budget Act to change the New Partnership Audit Rules effective date to December 31, 2018. Stating the rules are significantly different from previous law, the AICPA argues “virtually every partnership currently operating in the United States, regardless of size, will need to amend its partnership agreement…in a time frame that simply is not feasible.”
While we wait for a decision on the AICPA’s request, it would be prudent to prepare for The New Partnership Audit Rules. While many of the changes are still uncertain given the lack of technical corrections and final regulations interpreting the rules, all partnerships and partners should make plans to have their partnerships agreements reviewed and amended prior to the arrival of new regulations.