BBA’s Changes Taking Effect Soon
The Bipartisan Budget Act of 2015 (BBA, signed into law on November 2, 2015) covered a variety of items, but one of the most significant items was the enactment of new rules governing tax audits of large partnerships. Section 1101 of the BBA establishes a new audit framework that generally focuses and collects tax at the partnership level, rather than solely at the partner level as it had been done in the past. As these new partnership audit rules are taking effect for tax years beginning in 2018, partnerships are advised to start evaluating and preparing for these new provisions now.
What to Expect From the New Partnership Audit Rules
The new partnership audit rules were enacted as an attempt to simplify Internal Revenue Service (IRS) audits of large partnerships. Under the current law covering partnership tax audits, the IRS determines audit adjustments to partnership items at the partnership level; it then must apply these adjustments to each partner’s share of partnership income or loss; determine the additional tax due (or refund owed) to each partner; and then collect the extra tax from each of the various partners.
The most significant difference in the new partnership audit rules is that they force the IRS to assess and collect the tax from the partnership for the partnership items adjusted for in the audit. This shifts the responsibility of the tax liability from the partners collectively to the partnership itself.
Partnerships Could Face More Tax; Changes May Be Needed
While the IRS and others may feel these new partnership audit rules may be a simpler and more efficient way of collecting assessed tax, there are several issues for the partners to understand. Partnerships and their partners must realize that the partnership may owe more tax from an audit than the combined amount of tax the partners would owe if they were instead assessed individually.
In addition, the new partnership audit rules require the partnership to pay at the partnership level the additional tax assessed in the audit, even though the tax years in the audit covered a period in which different partners owned the partnership. Thus, the current partners in the year of the audit would be assessed a tax that related to tax years that had different partners. Therefore, a partnership subject to these new audit rules will need to review their partnership agreements and analyze any changes that may be needed so that some partners (current and/or prior) are required to reimburse the partnership for these tax assessments.
Effective Date and Scope of New Partnership Audit Rules
The new partnership audit rules are generally effective for partnership taxable years beginning after December 31, 2017 (unless Congress or the IRS decides to defer this effective date). Early adoption of these rules is also permitted.
Can/Should You Elect Out?
Partnerships are subject to these new partnership audit rules unless they elect out or opt out of the new provisions. The decision to elect out of these new partnership audit rules must be made by the partnership on a timely filed partnership tax return. In addition, this election is made annually; it is not just made in one year and for all future years.
For a partnership that elects out of these new rules, the IRS will be forced to proceed in its audit process with each partner directly for the partnership adjustment items; and will resolve issues, make assessments, and collect any tax that is triggered from these adjustments.
Not all partnerships are eligible to elect out of these new partnership audit rules. The following two requirements must both be satisfied for a partnership to be entitled to elect out of the partnership audit rules:
- First, the partnership must have 100, or fewer, partners in it.
- And second, the partnership must only have “eligible partners” defined as: individuals; C Corporations; S Corporations; foreign entities that would be treated as C Corporations if they were domestic; and estates of deceased partners. Thus, any partnership that has another partnership or multi-member LLC as a partner cannot elect out. Neither can a partnership that has a trust as a partner.
Therefore, each partnership will need to determine if it is entitled to “elect out” of these new audit rules, and if so, evaluate whether it wants to elect out of the rules. If so, they need to remember to make this election in their timely filed partnership tax return, and then remember to perform this same analysis the following year. If the partnership makes the election to opt out of these partnership audit rules, it must provide to the IRS the names and taxpayer FEIN numbers of each partner, and each partner must be given notice of the election.
Requirement to Elect a Partnership Representative
In hopes of making it smoother for the IRS (and perhaps taxpayers) to conduct a tax audit, the new partnership audit rules require each partnership to designate a “Partnership Representative” to serve as the one party acting between the IRS and the partnership for the audit. This new arrangement with the Partnership Representative is a key role in an audit, and this person has much responsibility for the audit, and in turn, there are no rights for the partners themselves in the examination.
The partnership itself must determine who will serve as the Partnership Representative. The representative does not have to be a partner to serve in this role, and the only requirement is that the representative has a substantial presence in the U.S. Again, the representative will be the only one with the authority to bind the partnership and all its partners concerning the tax audit. Therefore, partnerships must carefully consider who to appoint in this role, what authority the representative is granted, and what liability protections might be needed for their decisions and actions. Further, if a partnership does not identify a Partnership Representative, the IRS may select one.
Other Ways a Partnership Can Avoid Paying a Tax Assessment
If a partnership does not, or cannot, elect out of the partnership audit rules and later endures an IRS audit, it may still be able to avoid directly paying a tax assessment.
One such way is for the partnership to decide to “push out” the partnership audit adjustment to the partners. This push out election will be available so that the partnership can decide to issue adjusted information returns to each partner showing their respective share of the audit adjustment, instead of having the partnership pay the tax liability.
The partnership must make this push out election within 45 days of receiving the notice of the final audit adjustment. If the election is made, the partners will, after receiving the information return, report the income and pay the additional taxes through a simplified, amended return process using either the calculation rules set forth in the regulations or a “safe harbor” amount.
Further, the adjusted income information is issued to those partners who were partners in the audit year, even if they are not partners in the year when the audit is conducted and the assessment is made against the partnership. This approach assures the new or current partners will not be assessed taxes of the partners who are no longer in the partnership for the year under audit, but prior to the audit itself.
Another way to keep the partnership itself from needing to pay any of the tax assessment is for all of the partners to agree to file amended tax returns. If all of the partners amend their tax returns with the amount of the additional income determined in the audit, there is no need for the partnership to pay the tax. This provision would require that all partners agree to file amended tax returns.
Steps You Should Be Considering Now
These new partnership rules are effective for tax years beginning in 2018, thus partnerships should be looking at these new provisions now. In addition, the IRS recently issued final regulations concerning these rules for impacted taxpayers and tax practitioners.
Here are a few items for partnerships and their partners to consider in evaluating these new rules:
- Review Partnership/LLC Operating Agreements and consider any amendments that are needed to address these new rules. For instance, if the partnership is eligible to opt out of the new partnership audit rules, the partnership agreement should decide if the partnership is required to make the election out of these rules (on an annual basis).
- Determine who will serve as the Partnership Representative. If this happens to be a partner, consider what changes might be needed if the representative is no longer a partner. Since the representative does not need to be partner to serve in this role, does the partnership still want a former partner to fill this role? Again, the partnership or operating agreement should address these situations. Also, please note that in the final regulations, the IRS permits the partnership itself to serve as the Partnership Representative, which might resolve these instances of a former partner put in this role.
- Decide on the actions that the Partnership Representative can take (or cannot take). Again, it is important to remember that this representative serves as the sole party in dealing with the IRS for the partnership in a tax audit.
- Analyze and resolve when the partnership should elect to pass out to the partners any IRS audit adjustments made to the partnership.
- Due to the potential for an assessment to be made by the IRS at the partnership level, the taxpayer and its independent auditors will need to consider whether any disclosure or liability must be reflected on the company’s financial statements.
These rules are designed to make things easier when faced with IRS audits, but they also present many changes, challenges, and other consequences for partnerships and their partners (both current partners and former partners).
Should you have any questions about the new rules and their benefits and applicability as it pertains to your partnership, please contact a Sikich advisor for more information.