By Christopher E. Axene, CPA
On Nov. 2, 2015 Congress enacted the Bipartisan Budget Act of 2015 and with this
legislation ushered in a new period for IRS audits of partnerships both large and small.
The IRS’ audit methodology for partnerships had previously been based largely on legislation enacted in 1982 (Tax Equity and Fiscal Responsibility Act of 1982 – “TEFRA”). Under the TEFRA unified partnership audit rules, the tax treatment of any partnership item is determined at the partnership level. Once the audit is complete the IRS then recalculates the tax liability of each partner in the partnership for the particular year under audit. Under these rules, only one administrative proceeding (at the partnership level) is necessary to resolve tax issues with respect to all partners. However the tax impact of any such adjustments must still be determined at the individual partner level. Also, under the TEFRA procedures, the IRS must notify all partners individually at the beginning of any partnership audit as – once the audit is concluded – identify any adjustments to income or deductions that the IRS ultimately makes. The IRS has complained for many years that these rules make it difficult for them to audit partnerships having hundreds or even thousands of partners. This is borne out in IRS statistics of large partnership audits. In 2012 the IRS only closed 84 large partnership field audits representing a 0.8% audit rate!
The TEFRA partnership audit rules do not apply, however, to partnerships having 10 or fewer partners (each of whom is an individual, a C-corporation or the estate of a deceased partner) unless the partnership proactively elects to have these rules apply (which few do). Thus for these partnerships the IRS generally follows the audit rules for individuals – auditing the partnership and each individual partner separately.
Finally, pursuant to the Taxpayer Relief Act of 1997 partnerships with 100 or more partners could elect out of TEFRA treatment. These so called “electing large partnerships” were then subject to IRS audit at the partnership level with any resulting adjustment then flowing through to the partners’ returns for the year the adjustment takes effect. Under these rules the IRS is only obligated to notify the tax matters partner of the audit and any resulting changes. Under the electing large partnership regime the individual partners generally have no standing to participate in any partnership level proceeding. Again, few partnerships elected to fall under these audit rules.
Out with the old and in with the new
The new legislation repeals both the TEFRA rules and the electing large partnership audit rules effective for tax years beginning after Dec. 31, 2017. However, partnerships may elect to apply these new rules for any tax year beginning after the date the legislation was passed – Nov. 2, 2015 – and before Jan. 1, 2018.
What’s changed? The new rules appear to adopt an audit methodology similar to the electing large partnership audit rules currently in force, with one important exception. Specifically, the IRS will audit the partnership items of income, loss, deduction or credit for a particular year of the partnership – the so called reviewed year – with any resulting adjustments to be taken into account by the partnership in the adjustment year.
What year constitutes the adjustment year depends on how the adjustment ultimately is being made. For example, if an adjustment results from an item that the partnership appealed and lost, the adjustment year, it appears, will be the year the appeal is closed without further action by the partnership. As discussed above, the new rules require the partnership, not the partners, to pay tax equal to the imputed underpayment.
Imputed underpayment is defined as the net of all audit adjustments for the reviewed year multiplied by the highest individual or corporate tax rate in effect for the adjustment year. A lower tax rate could apply where additional information provided by the partnership (on behalf of the partners) indicates a lower rate might be appropriate. However, additional guidance is needed from the IRS in this area to understand how this provision will apply.
These new rules are not without some controversy as the flow-through entity itself is now tasked with bearing the cash tax consequences of any adjustments. The entity will need additional guidance from the IRS on how these payments are to be accounted for (e.g. distributions) and how to handle situations where the adjustment year partner group differs from the partner group in the reviewed year.
The new rules notwithstanding, a partnership may file an election no later than 45 days after notice of final partnership adjustment is received to issue adjusted information returns to the reviewed year partners. Those partners would then take the adjustment into account on their individual returns in the adjustment year via an amended return process.
No more tax matters partners. Under the new rules the partnership must designate a partnership representative. Based on the guidance the representative must have a substantial physical presence in the U.S. to qualify but need not actually be a partner in the partnership. As far as the IRS is concerned the partnership representative will have sole authority to act on behalf of the partnership. The IRS also has the authority to appoint a partnership representative if the partnership hasn’t already designated one.
Any partnership with 100 or fewer qualifying partners (as measured by number of k-1s issued) can choose to elect out of these new rules for any tax year by filing an election (under guidance to be provided by the IRS) with the partnership’s timely filed return. Partnerships that have upper tier partners as owners are not currently eligible to elect out. However the IRS has the authority to issue by regulations or other guidance rules making them eligible to elect out.
More to be decided
There are still many unanswered questions that must be addressed by the IRS to fully understand how these new rules should be implemented and when, for example, it may be advantageous to elect out. However, at a minimum partnerships (and LLCs taxed as partnerships) should begin now to review their partnership/operating agreements to review existing provisions and consider which ones may need to be revised in anticipation of the effective date of these new rules.
Christopher E. Axene, CPA, is principal at Rea & Associates, Inc.