United States: Partnerships: Get Ready For New Audit Rules

For partnerships, including limited liability companies taxed as partnerships, new audit rules are a game-changer. The rules apply to returns for partnership tax years that begin after December 31, 2017, including amended returns. The changes are not merely procedural and they substantially alter the taxation of partnerships by effectively imposing entity taxes on partnerships.

There is plenty of time to prepare for the new rules, but you should begin thinking about how they will affect you. If you are contemplating a new business venture that will be taxed as a partnership, it is a good idea to address the new rules in your partnership or operating agreement.

Tax on All Partnerships

The Bipartisan Budget Act of 2015's new audit rules will affect all partnerships, regardless of size. However, certain partnerships with 100 or fewer partners will be able to opt out of the new rules, but this process involves additional reporting and disclosure requirements.

Under the new rules, the IRS will assess and collect taxes at the partnership level. This is a significant departure from current rules, under which the IRS generally assesses and collects taxes at the individual partner level. By easing the administrative burden associated with collecting tax from individual partners, the new rules will likely produce a dramatic rise in the number of partnership audits.

Tax Assessed at Highest Rate

The new rules do not just streamline the audit process. In some cases, they will actually increase the aggregate tax liability of the partnership and its partners. In an audit under the new rules, the IRS will determine any adjustments to the partnership's income, gains, losses, deductions or credits and assess any additional taxes, penalties and interest against the partnership. Additional taxes will be determined by multiplying the net adjustment by the highest marginal individual or corporate tax rate for the audited year. The result is an imputed underpayment that the partnership takes into account in the adjustment year.

This approach will create several problems for partnerships and their partners. For example, because the new rules assess the tax at the highest marginal rate, partners lose the benefit of partner-level tax attributes that ordinarily would reduce their tax liability. To ease this burden, partnerships will be allowed to reduce their imputed underpayment by proving that a portion of it is attributable to tax-exempt partners, partners taxed at lower rates or income taxed at lower rates (such as capital gains). Compiling this information from all your partners may be time consuming.

Tax Mistakes of Others

Since the new rules take additional taxes into account in the adjustment year, current partners may be liable for tax mistakes that benefited former partners. However, two exceptions will allow a partnership to shift the liability back to its former partners. Partnerships can reduce or avoid entity-level taxation by:

  • Having the partners from the year under review file amended returns reporting their distributive shares of partnership adjustments and pay the tax within 270 days; or
  • Within 45 days after the audit, make an election to provide partners from the year under review with adjusted information returns. Those partners would then take the adjustments into account on their individual returns for the adjustment year.

These exceptions allow you to avoid inequitable results, but meeting them could be a challenge.

No More Tax Matters Partner

By the time the new rules take effect, you will need to replace your tax matters partner with a partnership representative. This person can be a partner or non-partner and must have a substantial U.S. presence.

Choose your representative carefully. He or she will have broad authority to bind the partnership and its partners in dealing with the IRS and partners will no longer have the right to participate in a partnership audit. Now is the time to begin the process of selecting a partnership representative.

What's Next?

The IRS is working on regulations that will clarify and modify the new rules. In the meantime, familiarize yourself with the rules and determine whether or not you will be eligible to opt out. If not, consider strategies for mitigating the impact, such as amending agreements to require partners to provide tax information and file amended returns in the event of an audit or indemnifying partners against unexpected tax liabilities.

Can You Opt Out?

Partnerships with 100 or fewer partners may opt out of the new audit rules by filing an annual small partnership election. However, before you jump to any conclusions about your partnership's status, be aware that you can opt out only if your partners are individuals, C corporations (including foreign entities that would be treated as C corporations, if they were domestic), S corporations or estates of deceased partners.

A partnership with just one non-qualifying partner does not qualify, regardless of its size. This means that tiered partnerships or limited liability companies generally will not be able to opt out. Also, for any S corporation partners, each shareholder counts as a partner for purposes of the 100-partner threshold.

If you opt out, in addition to filing annual elections, you will need to inform your partners of the choice to opt out and provide certain information to the IRS about each partner, including shareholders of S corporation partners.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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