Partnership Audit Rules Revised Under 2015 Budget Act
It is rare these days for Congress and the IRS to see eye to eye on anything. However, with Congress needing additional revenue to support raising the federal debt ceiling and lifting mandatory spending caps on defense and domestic programs, The Bipartisan Budget Act of 2015, signed into law on November 2, 2015, drastically changes the procedures the IRS follows in auditing partnership tax returns.
Congress has expressed concern over the low audit rate for partnerships (and LLCs that are treated as partnerships for tax purposes). The IRS agrees that the audit rate is too low. Various reasons have been cited to explain this including complexity of the existing partnership audit rules, rapid growth in the number of businesses operating as partnerships, complexity of current partnership structures especially multiple-tiered partnerships, and a lack of resources at the IRS.
Currently, there are three sets of rules governing examinations of partnership returns:
- Unified partnership audit rules. Under the Tax Equity and Fiscal Responsibility Act (TEFRA), for most partnerships with more than 10 partners, the IRS conducts a single administrative proceeding to resolve audit issues involving partnership items that are more appropriately determined at the partnership level than at the partner level. This complicated and difficult to administer procedure requires the IRS to recalculate the tax liability of each partner in the partnership for the particular audit year (not the year in which the examination is conducted and concluded).
- Small partnership rules. The unified audit rules don’t apply to any partnership having 10 or fewer partners, each of whom is an individual (other than a nonresident alien), a C corporation or an estate of a deceased partner — unless the partnership elects to have the unified audit rules apply. For such partnerships, the IRS generally applies the audit procedures for individual taxpayers, auditing the partnership and each partner separately.
- Electing large partnership rules. Simplified audit procedures apply to large partnerships with 100 or more partners who elect to be treated as electing large partnerships for reporting and audit purposes. Under these procedures, the IRS generally makes adjustments at the partnership level that flow through to the partners for the year in which the adjustment takes effect. The current-year partners’ shares of current-year partnership items of income, gains, losses, deductions or credits are revised to reflect partnership adjustments that take effect in that year. Adjustments generally won’t affect prior-year returns of any partners (except in the case of changes to any partner’s distributive shares).
The revised rules
The budget act repeals these procedures, replacing them with a streamlined single set of rules for auditing partnerships and their partners — and assessing and collecting any tax attributable to adjustments made in an audit at the partnership level.
The new rules generally apply to partnership tax years that begin after December 31, 2017. However, except for the election-out rules for small partnerships, covered below, partnerships may elect (as directed by the IRS) to have the new rules apply to any partnership return filed for partnership tax years beginning after November 2, 2015, and before January 1, 2018.
Under the new streamlined audit approach, any adjustment to items of income, gain, loss, deduction or credit of a partnership for a partnership tax year (and any partner’s distributive share of such adjustment) is determined at the partnership level. Similarly, any tax attributable to such adjustment is assessed and collected — and the applicability of any penalty, addition to tax or additional amount that relates to an adjustment to any such item or share is determined — at the partnership level.
The IRS will examine the partnership’s items of income, gain, loss, deduction or credit and partners’ distributive shares for a particular year of the partnership (termed the “reviewed year”), and any adjustments will be taken into account by the partnership — not the individual partners — in the “adjustment year.” What constitutes the adjustment year depends on how the adjustment was made.
Partnerships must pay tax equal to the “imputed underpayment,” which generally is the net of all adjustments for any reviewed year multiplied by the highest individual or corporate tax rate. However, the imputed underpayment may be modified if a partnership shows that a lower amount is appropriate based on certain partner-level information.
Additional aspects of the revised rules include:
Partner-level adjustment alternative. As an alternative to taking the adjustment into account at the partnership level, a partnership can make an election, not later than 45 days after a notice of final partnership adjustment, to issue adjusted information returns to the reviewed-year partners. If this election is made, the partners take the adjustment into account on their individual returns in the adjustment year through a simplified amended-return process. The election must be made in the time and manner prescribed by the IRS, and once made can be revoked only with the IRS’s consent.
Additionally, the new rules permit some (or all) of the partners, instead of the partnership, to pay their share of the tax on the partnership adjustment by filing an amended return. In this situation, the tax is computed and paid by adjusting taxable income items and credits in the reviewed year. An adjustment that reallocates the distributive share of a partnership item from one partner to another can only be used if all of the partners affected by the adjustment file an amended return.
Administrative adjustment alternative. Under the new rules, making voluntary adjustments to partnership taxable income – which is commonly referred to as amending a partnership return but is actually an Administrative Adjustment Request – is accomplished under procedures similar to the new audit rules, with the adjustment taken into account in the adjustment year. The partnership generally would be allowed to account for the adjustment at the partnership level or issue adjusted information returns to all those who were partners in the year under review.
Partners’ returns. On a partner’s return, under the “consistency requirement,” the partner must generally treat each item of income, gain, loss, deduction or credit attributable to a partnership in a manner that is consistent with the treatment of the income, gain, loss, deduction or credit on the partnership return.
Small partnership election out of new rules. Similar to the TEFRA rule excluding partnerships with 10 or fewer partners, partnerships with 100 or fewer qualifying partners can elect out of the new rules for any tax year. Currently, partnerships with other partnerships (or LLCs) or trusts as partners are not eligible to elect out. It is important to note that the election out is an affirmative election that must be made annually. In addition, the partnership must make sure that all partners can be identified by the IRS. If an S Corporation is a partner, the partnership must include identifying information for all of the S Corporation’s shareholders in the election.
Who can participate in the audit? Unlike current law where any partner generally has the right to participate in a partnership audit, under the new rules, only the partnership and a single, designated partnership representative will be permitted to participate. Interestingly, the designated partnership representative need not be a partner. However, the partnership and all of the partners will be bound by actions taken by the partnership (or the partnership representative) in the audit and by the final decision in the proceeding. The statute does not provide for a method to remove a partnership representative.
What should you do now?
If your company is organized as a partnership, you’ll want to take the time to familiarize yourself with the revised partnership audit rules included in the recent budget act. Moreover, there may be provisions in your partnership agreement (or LLC operating agreement) that deal with IRS audits under the existing rules. You will likely need to modify these provisions before 2018 to take into account the new rules. When they go into effect, you could be at a greater risk of being audited, and the rules are complex.
If you are admitting new partners, if someone (such as a former spouse of a partner) is becoming a successor in interest to a partner, or if you enter into an agreement to sell your partnership, expect significantly more rigorous due diligence procedures.
As with most hastily passed legislation, we are anticipating technical corrections to eliminate inconsistencies and clarify certain areas. In fact, our partner Michael Greenwald, head of our Business Entity Tax Practice and also Vice Chair of the AICPA’s Partnership Tax Technical Resource Panel, is hard at work helping draft the AICPA’s suggestions for technical correction language. Also, the IRS has broad latitude to issue regulations implementing these procedures so expect to see some changes to the rules discussed above between now and when they become effective. As always, please feel free to contact your Friedman LLP tax professional with any questions.