Partnerships Must Adapt to New IRS Audit Rules, Liabilities at the Entity Level – UPDATED Under Tax Reform
Posted on January 08, 2018
For more than three decades, IRS partnership audits have operated under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), which required individual partners to pay their share of a partnership’s tax underpayments identified in an IRS audit, unless the partnership elected to be taxed at the entity level. Since TEFRA’s enactment, partnerships have proliferated in number, size, and complexity, making it difficult for the IRS to audit and collect taxes from partners in larger and more complex entities. To solve this problem, Congress enacted sweeping changes to the IRS audit rules in the Bipartisan Budget Act of 2015 (BBA). Beginning in the 2018 tax year, the BBA will require partnerships, rather than individual partners, to be liable for income taxes on all adjustments of partnership income, gains, losses, deductions, credits, and related penalties and interest.
While early adoption of the new rules is permitted, partnerships should be prepared for how these changes will affect the valuation, taxation, and protection of their current and future partners’ interests.
The New Partnership Audit Rules
Under the new partnership audit rules, the burden to pay underreported taxes identified by an IRS audit shifts from individual partners to the partnership in the year the IRS makes the adjustment (the adjustment year), rather than in the year under audit (the audit year). With this change, a partnership will be responsible for correcting an “imputed underpayment” and remitting taxes at the highest individual rate (39.6 percent in 2017), plus penalties and interest in effect during the adjustment year, rather than the audit year. This change allows the IRS to collect unpaid taxes directly from a partnership rather than its partners. Consequently, under the BBA, a partnership’s current partners may be liable to pay for tax benefits former partners erroneously received in prior years.
To account for this discrepancy, the new rules allow a partnership to elect tax treatment at the partner level and transfer audit year tax liabilities back to audit year partners when the partnership takes one of the following actions:
- Within 45 days after receiving an IRS Notice of Proposed Adjustment, the partnership can make a Section 6226 election to issue to all partners during the audit year examination revised K-1s or similar statements, reflecting each partner’s share of items adjusted by the IRS. If the partnership elects out of the default rules, each partner would be required to pay taxes for the audit year when the revised K-1 is issued. Penalties and interest on the underpayment of tax will accrue from the audit year.
- Within 270 days after receiving an IRS Notice of Proposed Adjustment, the partnership can issue updated K-1s to all affected partners and convince those partners to file amended tax returns incorporating the IRS adjustments. All affected partners would be required to pay the additional taxes, penalties and interest for all directly and indirectly affected years.
Time constraints on these elections may cause difficulties for many partnerships, especially those filing an administrative appeal. Oftentimes, the appeal process may take more time to resolve than the 45- to 270-day timeframe partnerships have to make an election. Additionally, if a partner-level election is made, the interest rate on tax underpayments will be increased by two percentage points.
Other Exemptions and Relief
The new audit rules apply to partnerships of all sizes for taxable years beginning after December 31, 2017. However, the law provides an opportunity for certain small partnerships to annually opt-out of the rules when they have 100 or less direct and indirect partners, all of whom are either individuals, C Corporations, foreign entities treated as U.S. C Corporations, S Corporations, or estates of deceased partners.
Taking advantage of this opt-out election requires qualifying partnerships to follow complex reporting and compliance requirements, which includes the obligation to provide the IRS with the names and taxpayer identification numbers of indirect partners who hold an interest in and may be liable for partnership tax liabilities. Also, when a partnership elects to opt-out, the pre-TEFRA audit rules will apply. This will typically mean that each partner will be audited separately.
Finally, partnerships that wish to avoid underpaid tax adjustments at the highest tax rate of 39.6 percent in 2017, can examine the effective tax rates of their individual partners. Partnerships may qualify for a lower tax rate when they can demonstrate within 270 days of receiving an IRS notice that certain partners qualified for a rate adjustment during the audit year because:
- Part of the identified underpayment was allocable to a partner that was a tax-exempt entity;
- Part of the identified underpayment was due to ordinary income allocable to a C Corporation partner or a capital gain or dividend allocable to an individual partner; or
- At least one partner files an amended return consistent with the final partnership adjustment and pays the tax in full.
Compliance with the new audit rules requires partnerships to appoint a person or entity “with a substantial presence in the U.S.” to serve as partnership representative (PR) to act on behalf of the partnership for all IRS matters. In contrast to the TEFRA rules, the PR does need not be a partner. Going forward, the IRS will only communicate with and issue notices to the sole PR who represents and binds the partnership and all of its partners in IRS audits and court proceedings. If the partnership does not appoint a PR, the IRS may appoint one for the partnership.
Regarding timing, a partnership may be able to apply the new rules retroactively to the 2016 or 2017 tax years only when it receives an IRS notice of examination or files a claim for refund for 2016 or 2017. To make this early opt-in election, the partners must timely file a signed statement conforming to the language and manner required by the IRS.
In 2017, the Treasury Department released proposed regulations on the new partnership audit rules. Additionally, a Tax Technical Corrections Act was introduced in Congress to address many of the issues arising from these new rules. While the rules may be modified in the future, partnerships should comply with the new law and understand how it will impact their operations. The following items should be addressed under the guidance of experienced tax professionals:
- How will the partnership select a PR to have sole authority in IRS matters?
- What processes will be employed to ensure the PR meets its reporting obligations to the partners and the IRS?
- Does the partnership qualify to opt-out of the new rules or lower its imputed tax?
- How should the partnership agreement be amended to address the new rules?
- Does the partnership have any exposure to imputed tax underpayments from prior tax years?
- How will the partnership handle tax liabilities incurred by prior partners?
- If the partnership issues financial statements, will it be required to accrue income taxes under GAAP or IFRS?
Tax Reform Impact
In December 2017, Congress passed a sweeping tax reform act, which includes several important changes involving partnerships. Beginning in the 2018 tax year, individual partners may deduct up to 20 percent of their share of their partnership’s “qualified business income.” The intended effect of this provision is to reduce the top tax rate on an individual partner’s share of qualified business income (QBI) to 29.6 percent, from the top individual rate of 37 percent that is effective under the new tax law. While a full discussion of this tax reform provision is beyond the scope of this article, its impact on partnerships will need to be addressed in future IRS examinations where the new partnership audit rules will apply. Depending on future regulations, IRS rulings, and other developments, the result of a partnership-level audit assessment could result in income adjustments from IRS partnership examinations of 2018 and future years to be taxed at 37 percent, versus an otherwise available 29.6 percent rate under new tax reform act. Proper planning and elections may mitigate these unfavorable results. Timely tax planning will be critical to ensure optimal tax results for partnerships and partners, given these major developments.