What is new?
The partnership audit rules were signed into law in late 2015, as part of the Bipartisan Budget Act of 2015. The changes under the new regime apply to returns filed for tax years beginning after December 31, 2017. That is, a partnership’s tax years beginning on or after January 1, 2018.
While the rules are no longer new, their true impact comes to the forefront this tax season when businesses must file tax returns for 2018.
Who is impacted?
The new regime affects the owners of business entities that file IRS Form 1065. Traditionally, that would include partnerships and multi-member LLCs that are regarded as partnerships for tax purposes.
Why is this important?
Essentially, the new regime streamlines the federal tax audit procedures for partnerships.
A prominent feature of a tax partnership is its flow-through status, which subjects partners to only a single level of taxation at the partner level. The partners, rather than the partnership, are subject to taxation.
The new legislation and regulations make exams more straightforward for the IRS. Unless exceptions apply, the IRS would no longer go through tiers of partners to audit owners of partnerships. Now, the IRS can audit the partnership’s tax return and collect tax from the partnership, not the partners.
Under the new regime, the IRS will look directly to the partnership to collect information, and will assess and collect tax, penalties, and interest at the partnership level. The liability for making payments will reside with the partnership. This means the likelihood of an audit would be greater.
States have been responding and state tax authorities have been adopting corresponding rules.
Do I need to act now?
Businesses must make certain tax audit decisions before filing partnership returns for tax year 2018. While these decisions must be made now for 2018, partnerships may choose to apply the same to tax years going forward.
Of course, the decisions may be simpler for some business entities and structures and more complex for others. In either instance, decision making takes time for coordination and deliberation.
What needs to be done for my partnership’s tax return? Select a representative.
At the very minimum, the partnership must select a representative to interface with IRS on audit issues. The representative must be listed on Form 1065, starting with its 2018 return. If a partnership has not selected a representative yet, it must do so quickly before filing for 2018. The representative can be an individual or an entity.
The partnership representative is akin to the old tax matters partner as this person serves as the liaison between the partnership and the IRS. Unlike the old tax matters partner, this partnership representative is omnipotent. The partnership representative has the sole authority to act on behalf of the audited partnership. While that representative can be replaced at prescribed times and under certain conditions, no partner has the authority to represent the partnership or intervene on its behalf in a partnership-level proceeding unless the partner is the partnership representative.
Under the new rules, if a partnership fails to designate a partnership representative or the designation is ineffective, the IRS may select any “person” as the partnership representative. The representative’s actions and decisions are binding on the partnership and its partners, so be sure to choose wisely.
What needs to be done for my partnership’s tax return? Consider the push-out election.
Partners may need to provide personal information for the preparation of the partnership’s 2018 tax return. Particularly if the partnership wishes to use the push-out election strategy if 2018 is audited in the future.
The push-out election allows the partnership to choose to push out the tax to the partners on record for the audited tax year. In turn, the audit-year partners become individually responsible for the associated tax liabilities and would take the audit adjustments into account on their own tax returns.
Each partner pays tax, interest, and penalties directly to the IRS on that partner’s share of any adjustments at that partner’s tax rate. The partnership has 45 days from the IRS’s mailing of the final notice to make this irrevocable election. To implement the push-out, the partnership must issue adjusted Schedules K-l to each audit-year partner to reflect that partner’s share of audit adjustments. The partners take these adjustments into account for the tax year when they receive adjusted Schedules K-l.
The alternative under the new default rules would be for the partnership, not the partners, to take the audit adjustments in the tax year when the adjustments are made. In that scenario, because payment would due from the partnership in the adjustment year, the adjustment-year partners may become responsible for tax benefits reaped erroneously in prior years by former audit-year partners.
What if my partnership or LLC does not want to be part of the new regime? Consider the opt-out election.
Only eligible partnerships can file an election to opt out of the new audit rules. If partnership opts out, the IRS would have to make adjustments to each partner’s tax return. Only partnerships that issue 100 or fewer Schedules K-l are eligible for opting out. Yet, being a small partnership, with 100 or fewer partners, is not sufficient by itself. The partners must be permitted partners. Examples are individuals, estates of former partners, S corporations, and C corporations.
Note that a partnership cannot opt out if it issues even a single Schedule K-l to a single trust, another partnership, disregarded entity, or certain other partners. If an S corporation is a partner in a partnership, then each Schedule K-l issued to an S corporation owner is counted for the 100-partner threshold. Spouses and their estates are treated as one partner.
The opt-out election is made on the partnership’s tax return on a year-by-year basis. For a partnership that intends to make the opt-out election for 2018, a decision is needed soon. Also, the partnership must file Schedule B-2 if it makes the election. Some partnerships may have viable restructuring options available to allow them to opt out if they so wish.
Do I need to do anything about my LLC Operating Agreement or Partnership Agreement?
In light of the new audit rules, Operating Agreements for LLCs and Partnership Agreements for limited and other partnerships should be updated. Revisions should be made to implement check-in mechanisms for the partnership representative triggered by milestone audit events. Setting specific parameters of action and imposing restrictions on the power of the partnership representative would be wise. For example, the partnership can require the representative to consult with the leaders of the partnership before hiring outside experts, agreeing to settlement, initiating litigation, or making other binding decisions. While best practices have been evolving, each partnership may have its own preferences for the level of oversight it wishes to exercise over its representative.
Further, partnerships should spell out in advance procedures and plans of action in case of an audit. The IRS will no longer notify individual partners of an audit. It would be on the partnership to take on that task when an IRS notice is received.
For small partnerships, consider adding language for restrictions on the transfer of partnership or LLC interests for the partnership to remain eligible for making the opt-out election. The agreement can specify that partnership interests cannot be transferred to any entity that would make the partnership ineligible for the opt-out election.
The handling of adjustments related to prior audit-year partners and the indemnification of adjustment-year partners by audit-year partners are two other significant areas of concern that should be addressed.