New IRS Partnership Tax Audit Rules are Now in Effect

Significant Economic Impact on Partners on the Horizon?

The 2015 Bipartisan Budget Act repealed existing TEFRA partnership audit procedures and replaced them with the new Partnership Centralized Audit Regime which takes effect for tax years beginning after 2017, or for any partnership that elects application for tax years beginning after November 2, 2015.

Under current TEFRA rules, if a partnership is audited and there is an adjustment, the IRS has to pass through the adjustment to all of the partners - which can be a time consuming and costly process. This has resulted in  a significantly lower percentage of audits of large partnerships compared to their corporate counterparts.

The new partnership audit rules  makes it easier for the IRS to audit large partnerships, and has a potentially significant economic impact on partners. For tax years beginning in 2018, the new audit procedures shift the liability for underpayment of tax and the related penalties and interest from the partners to the partnership.

Designating a Partnership Representative Under the New Partnership Tax Audit Rules

Under the new rules, a tax matters partner is no longer relevant.

Instead, partnerships must designate a partnership representative. Congress gave the partnership representative a broad range of authority to act on the partnership’s behalf, and to bind the partnership and the partners without their direct knowledge or involvement.

The proposed regulations on the new rules state that no state law or partnership agreement can limit the authority of the partnership representative. The partnership representative will ultimately decide whether or not to accept a proposed adjustment, to have the partnership pay the tax, or elect to push it out to the partners (discussed in more detail below).

Given that the partnership representative has so much power we expect partnerships to review their operating agreement and decide who should be the partnership representative.

We also expect some partnership agreements to state whether or not to elect out of the new regime, or if not applicable, to push-out the adjustment, or have the tax paid by the partnership. Although it doesn’t appear the IRS would be bound by these provisions in the agreement and would ultimately follow the decision of the partnership representative, this may give partners some recourse against the partnership representative.  

If the partnership does not choose a representative the IRS can.

A Partnership Level Tax?

The tax computed from any adjustments resulting from an audit will be multiplied by the highest individual or corporate tax rate in effect for that year. This could result in a significantly higher tax than had the adjustments been pushed out to the partners and computed on their respective returns.

However, partnerships are allowed to show to the IRS that the underpayment would be lower based on certain partner level information including amended returns, tax exempt partners, or a lower tax rate.

If the partnership decides to pay the tax,  the current partners effectively bear the economic burden for past liabilities even if they may not have been a partner or received an economic benefit from the partnership.

Pushing Out Tax Adjustments to Partners

The partnership can elect to “push-out” any adjustments resulting from an IRS audit to partners who were in the partnership in the year of the relevant adjustment.

This would effectively shift the economic burden back to partners who were allocated the benefit in the prior year. Those partners take the adjustment into account in the year the statement is furnished. 

For example, if the IRS finalized an audit of a 2018 tax year in 2020, the partners would account for the push-out adjustment on their 2020 tax returns. This convenience comes at a cost, the partners will pay interest on any underpayment at a rate that is 2% higher than the normal interest rate.

Further, applying the adjustment on an individual return will likely mean higher tax preparation fees.

Electing out of the New Tax Audit Rules for Partnerships

Partnerships can elect out of the new rules entirely.  One reason why partnerships may want to elect out of the rules is because  upon notification of any proposed adjustments, any individual  partner can protest an adjustment they disagree with. However, under the new rules, a partnership representative has the sole authority to act on behalf of the partnership.

The partnership must notify each of its partners of the election within 30 days of making the election, and the partnership and its  partners are bound by the election.

However, only certain partnerships will be eligible for this election.  

In order to elect out the partnership must have 100 or fewer eligible partners. An eligible partner is an individual, C or S corporation, foreign entities that would be treated as C corporations if they were domestic, and estates of deceased partners. Each shareholder of an S corporation is counted separately in determining the 100 or fewer partners.

Partnerships, trusts, nominees that hold an interest on behalf of another person, and disregarded entities are all ineligible partners and therefore a partnership with an ineligible partner would not be able to elect out of the new rules.  

In order to elect out, an election must be made with a timely filed return (including extensions) each year the partnership wishes to elect out.  If you are eligible to elect out,  you are going to need to discuss the election with your partners before the return is filed.

Preparing for the New Partnership Tax Audit Regime

There are still many uncertainties related to the new rules as a number of the Regulations remain in proposed form and only the Regulation dealing with the election out has been finalized as of the date of this article.  

But we do know many partnerships are not going to be able to elect out of the new centralized audit regime, either because they have more than 100 partners or have an ineligible partner such as a partnership, trust or disregarded entity.

As a result, there is potentially a significantly different economic impact depending on how a partnership chooses to apply the new rules. We believe different facts and circumstances will lead to different applications of the new rules and each partnership needs to discuss these and identify which is best for them.  

Maybe the partnership paying the tax is easier and has less compliance costs than pushing out the adjustment, or maybe the partnership just doesn’t want to burden its investors with the audit adjustment, so paying the tax at the partnership level is the best choice. Others may find that due to ownership changes this unfairly hurts the existing partners and pushing out the adjustment is the best choice.  

For new partners it will be more important than ever to address this issue before investing and existing partnerships will be best served to address these rules before an issue arises

Talk to an Expert in Partnership Taxation Issues

One of the consequences of the new audit regime is that elections will need to be discussed, impacts on both the partnership and individual partner level will need to be analyzed, and in all likelihood, partnership agreements will need to be amended.

The Partnership Taxation experts at Freed Maxick can help. We would be happy to help you understand how the new partnership tax audit rules will affect your business so you can make the best decisions for amending your partnership agreement..

To schedule a complimentary review of your situation, click here to submit a form and request a complimentary consultation.

For more insight, observations and guidance on the new Tax Cuts and Jobs Act, visit our Tax Reform webpage.