Are You Ready for Changes to Partnership Audit Rules in the New Year? by Andreea Cioara Schinas, CPA
Posted on November 13, 2017 by Andreea Cioara Schinas
Partnerships and LLCs must be prepared to contend with new rules for how the IRS will assess and collect tax deficiencies identified under audit for tax years beginning on Jan. 1, 2018. With just a few weeks left in 2017, partnerships have a limited amount of time to consider how the new rules will affect them, and how they may take action if they have not done so already.
On June 13, 2017, the IRS re-released proposed regulations that it originally circulated in an unofficial form on January 19, 2017, on the new partnership audit rules enacted by the Bipartisan Budget Act of 2015 (BBA). Under the new rules, the responsibility for all adjustments of partnership income, gains, losses, deductions, credits, and related penalties and interest will shift from the individual partners to the entity itself.
The BBA replaces the current partnership audit and adjustment rules that have been in place for more than 30 years under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). Under that regime, each individual partners bore the burden of paying any of a partnership’s tax underpayments identified under audit. The IRS would recalculate each partner’s return for any adjustments at the entity level and send to each partner a bill for tax deficiencies.
In contrast, under the BBA, the IRS will now require the partnership entity to collect and remit taxes at the highest individual rate (currently at 39.6 percent), plus penalties and interest, in effect during the year in which the agency uncovers the underpayment (the adjustment year), rather than the audit year. As a result, it is possible that an entity’s current partners will be responsible to pay for the tax liabilities of its former individual partners, who would have received the tax savings in prior years. In addition, the new rules do not allow partnerships to deduct any payments of tax, interest and penalties relating to a prior year’s underpayment. Instead, the payment of tax understatements would be treated as a nondeductible item allocable to the current partners.
Another significant change under the BBA is a new requirement that partnerships assign one person to serve as the entity’s sole representative in all tax and legal matters with the IRS. While the selected representative does not have to be a partner in the entity, he or she must be a person or entity with a substantial presence in the U.S. Should a partnership or LLC fail to update its existing partnership agreement with the appointment of a personal representative, the IRS will make the selection on the entity’s behalf.
The Push-Out Election
The personal representative has the option to make a push-out election. Under the election, the partnership issues revised tax information returns (Schedules K-1) to affected partners and the partnership isn’t financially responsible for additional taxes, interest and penalties resulting from the audit.
The push-out election allows the partnership to push the effects of audit adjustments out to the partners that were in place during the tax year under review. This effectively shifts the resulting liability away from the current partners to the partners that were in place during the tax year to which the adjustment applies. The push-out election must be filed within 45 days of the date that the IRS mails a final partnership adjustment to the partnership. This deadline cannot be extended. The proposed regulations specify the information that must be included in a push-out election. The partnership must also provide affected partners with statements summarizing their individual shares of adjusted partnership tax items.
A partnership should update its agreements to address whether the partnership representative is required to make the push-out election or the circumstances in which a push-out election will be made.
The Opt-Out Election
A very limited exception permits certain small partnerships to elect annually to opt out entirely from the BBA rules. To qualify for this opt-out election, a small partnership must have 100 or fewer partners, and it must be composed entirely of individuals, C-corporations, S-corporations, foreign entities treated as a C-corporations, or estates of deceased partners. The opt-out election is unavailable to a partnership that has a flow-through entity as a partner (such as another partnership or LLC). It is important to note that even partnerships making the opt-out election must appoint a partnership representative.
Actions to Take
It will become more important than ever that partnerships identify any potential issues that could result in an imputed underpayment. They will need to more closely review partnership agreements to consider whether the entity can elect out of the new regime and push these obligations out to the former partners, or if it will be obligated to pay any tax liability with current partnership assets.
This will undoubtedly require entities to conduct significant due diligence and potentially revise existing partnership agreements. It may also require modifications to the structure of partnerships to better manage its risks and potential exposure to a partnership level tax liability. Should a partnership decide to pay taxes and penalties at the entity level, it will need to consider how the current partners will bear the payment. Conversely, if the partnership opts out of the new standard, it will need to have systems, policies and procedures in place for making such elections. It will also need to reach out to former partners, calculate their obligations and ensure that the make required payments. No matter what decision the partnership makes, it can expect that the new standard will impact its financial statements and disclosures, both retroactively and in the future.
Time is of the essence for partnerships to make sense of the new audit standard and understand how it will impact the risks, liabilities and opportunities it will bring to the entity and its current and former partners. The advisors and accountants with Berkowitz Pollack Brant work extensively with domestic and international entities, including real estate developers and investors, to meet complex regulations and ensure maximum tax efficiency.
About the Author: Andreea Cioara Schinas, CPA, is a director with Berkowitz Pollack Brant’s Tax Services practice, where she provides corporate tax planning for clients through all phases of business operations, including formation, debt restructuring, succession planning and business sales and acquisitions. She can be reached in the CPA firm’s Ft. Lauderdale, Fla., office at (954) 712-7000, or via email at firstname.lastname@example.org.