Partnership Audit Rules Have Changed Under New Tax Law
Congress enacted the Bipartisan Budget Act of 2015 (“BBA”) under which existing partnership audit rules have been replaced. The new BBA audit rules are broad and complex and effective for partnership tax returns filed for tax years beginning in 2018. Under the prior audit rules, the tax liability flowed through to each partner. Under the new audit rules, the tax is as assessed at the entity level. This is a critical change. Most partnerships and limited liability companies that are taxed as partnerships, will need to amend their partnership agreements and operating agreements.1 There can be harsh tax consequences and partner’s interests may be limited if certain elections are or are not made.
Highlights of BBA
- Effective for returns filed for tax years starting in 2018.
- Prior rules are repealed.
- Unless the partnership opts out, partners will no longer have the right to participate in tax audits, administrative appeals or tax litigation.
- Tax on “imputed underpayments” is assessed at partnership level unless the partnership makes an election to push the tax assessment to the partners. 2
- “Tax Matters Partner” is replaced by a “Partnership Representative”. The Partnership Representative does not need to be a partner. If the partnership is under audit, and a Partnership Representative has not been named by the partnership, the IRS will appoint the Partnership Representative.
- All Partnership Agreements will still need Tax Matters Partner for intervening years. BBA audits will not occur immediately.
- In an audit, under any subsequent appeals and/or court proceedings, The IRS taxes the partnership at the highest rate - 37% for individuals and 21% for C corporations.
Designation of Partnership Representative is Crucial
- Each partnership must appoint a Partnership Representative. The Partnership Representative has the sole authority to act on behalf of the partnership.
- Partnership Representative must be a person with substantial U.S. presence. 3
- If a Partnership Representative is not appointed, or declines to serve, the partnership agreement should have a default provision.
- a general partner of a partnership or the manager or members of a limited liability company may appoint a Partnership Representative if there is none serving.
- partnership agreement should require the Partnership Representative to agree to serve.
Election Out of Partnership Audit Rules
- Partnership with 100 or fewer partners can opt out of the entity level assessment by:
- Annual election
- However, they must include name and TIN for each partner
- Questions about opt out rules:
- Are community spouses treated as one or two partners?
- If a partner dies, do the people receiving interests increase the number of partners?
- To make the election, partners must be:
- S corporation (To pass the 100-partner test, they must count all shareholders and disclose to shareholders what the election is for)
- Estates of deceased partners
- Partners cannot be upper tier partnerships. These means that partnerships cannot hold own partnership interests within the same partnership or trusts.
- If opt out is granted, there is the possibility of having 100 different audits and 100 different results.
Determination of Tax Liability at Partnership Level
- All partners are bound.
- Partners have no right to participate in proceedings with the IRS.
- Penalties assessed at partnership level – no individual partner has a defense to penalties.
- Only partnership statute of limitations is relevant.
- Tax assessment is made in the adjustment year (when assessment is made) not the reviewed year (year being audited).4
- Partnership can submit evidence to modify assessment of the highest individual tax rate if
- a partner is a tax-exempt entity or
- a partner who is and individual is receiving an allocation of capital gains or dividends subject to reduced tax rates for these items.
Taxation at Partner Level
- The Partnership Representative must elect to push out the tax to the partners (“Push Out Election”). The partnership must notify each partner of the Push Out Election.
- IRS will make determinations at partner level.
- Push Out Election must be made within 45 days after partnership receives final adjustment from IRS.
- Partnership may issue statements (similar to K-1) to partners during review year.
- Partners receiving statements are subject to tax for the review year.
- Tax equals amount that would have been due in reviewed year and any intervening years, if there was an increase due to IRS adjustment to tax attributes.
- Reviewed year partners are liable for interest and penalties. Calculated at normal interest rate plus 2%.
- There is no joint and several liability.
- Partners cannot consent to issuance of statements or amount of adjustment
- Partners may choose to pay a “Safe Harbor” amount
- Should the push-out election be optional or mandatory?
- What is impact on current partners vs. prior partners?
- Partnership will need covenants that both current and former partners will provide all required information to the partnership and will pay any assessed tax
- Does the partnership’s lender have a preference or is there a requirement in the partnership loan documents?
- Should the partnership agreement have a requirement to elect out or make the push-out election?
- If partnership sells its assets and liquidates what are provision for post-termination audits
- If partnership sell business line, what is impact of partnership tax liability in documents?
The new partnership audit rules are very far-reaching and complicated. Partnerships need to carefully review their partnership agreements. The new rules apply to both simple and complex partnerships. For example, they apply to an entity taxed as a partnership that has a joint revocable living trust as an owner for the benefit of a husband and wife. They also apply to sophisticated partnerships that have multiple partners and even multiple partnerships nesting within the partnership.
We recommend that all partnership agreements be reviewed and amended to address these issues. The most important starting point is to name the Partnership Representative so the IRS can’t and doesn’t name one for the partnership. Please contact us if you would like to discuss how the rule changes impact your partnership or limited liability company.
About the author: Beth S. Cohn is a shareholder at the Phoenix law firm of Jaburg Wilk. She chairs the business law department and assists clients with estate and business planning. She is a State Bar of Arizona certified tax specialist and a CPA
1 All entities that are taxed as partnerships may be referred to as “partnerships”, all partnership agreements and operating agreements may be referred to as “partnership agreements” and partners and members may be referred to as “partners”.
2 This means if the tax is assessed at the partnership level, it is paid by the partnership and if it is assessed at the partner level, it is paid by the partner.
3 “Person” includes an individual, trust, estate, partnership, association, company or corporation. Guidance is needed as to who can serve as an authorized representative of a Partnership Representative that is an entity.
4 One of the biggest problems that has not been addressed under the BBA is what happens in the case of an assessment at the partnership level when the partners have changed and are not the same in the assessment year as in the reviewed year. The same issue applies if the election is made to “push out” the taxes to the partners.