The new IRS centralized audit procedures for partnerships

Written on Nov 13, 2017

By Michael Bowman, CPA

Partnerships provide flexibility and other operational, legal and tax benefits for companies large and small. Financial executives and entrepreneurs often utilize partnerships when reshaping an existing legal structure or starting a new business. Likewise, investors and financiers often select partnerships as investment vehicles or holding companies.

The volume and complexity of partnership filings has increased over time. In response, the Department of the Treasury (Treasury) and IRS have changed the manner in which partnership tax filings are examined, required audit adjustments are made and tax due is collected.

Prior to the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) and the electing partnership rules, when a partnership was selected for audit, the assigned IRS examination agent or team would audit every partner in the entity individually, which was costly and time consuming. The TEFRA and electing partnership rules were written to streamline IRS examinations by providing that certain items could be reviewed at the partnership level while other needed adjustments could be pushed down to the affected partners.

Despite efficiency gains, this approach can be problematic because every partner in a partnership has a different set of circumstances (e.g., statutes of limitation, tax status, etc.) and a profile mix can create inconsistent treatment and outcomes for partners. Large partnerships and multi-tiered partnership structures also created challenging workloads for regulators because of the layers of modifications, tax notices and tax assessments.

These issues have made it hard to scrutinize large partnerships. The IRS audit rate of large partnerships, for instance, is less than one percent. By comparison, in 2012, 27% of large corporations were selected for audit1. That discrepancy distorts the legal entity selection decision and can drive down tax revenue for the federal government. Taxpayers, tax practitioners and some regulators have also criticized the TEFRA and electing partnership rules because of their complexity and rigor.

The ongoing dialogue on the topic and desire to increase government revenues led to the centralized partnership audit regime concept enacted by section 1101 of the Bipartisan Budget Act of 2015 and amended by the Protecting Americans from Tax Hikes Act of 2015. The Treasury staff believe the regime will streamline examinations and make collecting tax easier for the IRS. Time will tell whether taxpayers view the new rules similarly.

The guidance issued by the Treasury to implement this legislation was first proposed in January 2017, but not published in the Federal Register because of President Trump’s regulatory freeze. The Treasury re-issued the proposed rules (REG-136118-15) on June 14 and solicited comments from taxpayers and practitioners in advance of a public hearing that took place on Sept. 15 in Washington D.C. The final rules are generally expected to be similar to the proposed rules.

The new regulations and regulatory framework is effective for all years beginning after Dec. 31, 2017, (early adoption is possible). Under the default rules of the centralized partnership audit regime, the partnership is liable for an imputed underpayment of tax based on adjustments made at the entity level. This is a significant deviation from current law and administrative procedure that treats partnerships as mere reporting agents rather than taxpayers.

In certain cases, the new audit regime’s imputed underpayment calculation could create higher tax liabilities than the existing rules, which mandate that the IRS determine each partner’s share of entity- level adjustments and compute tax at the partner level. To avoid such scenarios, partnerships can elect general modification procedures and amend tax returns. The rules also give additional authority to the IRS to adjust imputed underpayments. The proposed rules suggest that, “Where all partners amend their returns taking all adjustments into account, the IRS, the partnership and its partners have effectively mirrored the result of a TEFRA audit, including the final partner-level computational adjustments.” Partnerships can also make a “push-out” election to avoid the default rules and mitigate proposed adjustments liabilities.

There are certain “eligible” partnerships that will be able to elect out of the general or default rules, but they must have 100 or less “eligible” partners. The rules define “ineligible” partners and provide special rules for S Corporations that taxpayers will need to review and monitor closely. Eligible partnerships will elect out of the general rules by making an annual election on a timely filed tax return.

The new rules also replace the Tax Matters Partner designation with a Partnership Representative (“Representative”) role. If the partnership does not have a Representative, the rules provide that the IRS can select the Representative and prohibit the partnership from selecting a new Representative without IRS consent.

The new rules give the Representative sole authority to act on behalf the partnership and make all decisions in relevant matters. Taxpayers should give serious consideration to updating partnership agreements to require that the Representative seek the consent of other partners before making binding decisions about adjustments, elections and other related matters.

The significant changes outlined in the new rules have prompted lengthy comments from tax practitioners. The Ohio Society of CPAs Federal Tax Committee submitted comments on the rules. In a comment letter sent to members of the House Committee on Ways and Means and the Senate Committee on Finance in July, the Section of Taxation of the American BAR Association asked for a delay in the implementation of the new rules in part because “virtually every partnership in the United States, including other types of business entities treated as partnerships for federal tax purposes, will need to amend its partnership agreement to address the important changes in the regime.” A member of the AICPA also rendered testimony at the public hearing and outlined various technical recommendations.

The significant changes outlined in the new rules will also require that state legislatures and tax departments determine how best to approach the central audit regime.

Until the final regulations are released, the full impact of the new rules on taxpayers cannot be fully known. It is clear, however, that partnerships should review the proposed rules now and begin reviewing partnership agreements in consideration of the various elections and other nuances of the new rules. Partnerships should also work with their auditors to fully consider the implications of the new rules on ASC 740 reporting.

Michael Bowman, CPA, is a senior manager at Schneider Downs.

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