Starting in 2018, changes in the partnership audit rules will impact partnerships and LLC’s taxed as partnerships. The Bipartisan Budget Act of 2015 changed the partnership audit rules beginning in 2018 by making the partnership, not the partners, liable for payment of any assessments from an audit. Also, the audit adjustments will now be reflected on the return for the year the adjustment is finalized, not the year under review.
Under the old rules, the federal income tax treatment of partnership items of income, gain, deduction and credit is generally determined at the partnership level, even though these tax items are passed through to the partners and reported on their returns. After a partnership audit is completed and the resulting adjustments to partnership tax items are determined, the IRS generally recalculates the tax liability of each partner and sends out bills for additional taxes, interest and penalties to the partners.
As the number of large partnerships grew, these rules created an administrative burden on the IRS so Congress established a new set of audit rules for partnerships. However, the old rules will continue to apply for the 2017 tax year.
Under the new law, required adjustments from an audit are taken into account at the partnership level, not by the individual partners. Also, the adjustments are reflected in the year the audit is complete, not the year under review. The IRS will collect the assessed amount including penalties and interest from the partnership and not the individual partners. The tax will be at the highest individual rate in effect for the audit year.
The partners in the current adjustment year will bear the impact of any adjustments arising from an audit, not the partners from the year under audit. If the partners have changed, those who are economically impacted may be different from those who were owners during the year under audit.
The new law does create options for partnerships to pass the adjustments through to the partners. One option, known as the “push-out election,” allows the partners to take the IRS-imposed adjustments to partnership tax items into account on their own returns. Or, if eligible, a partnership can elect out of the new rules altogether.
The Push-Out Election
As noted above, under the new rules, a partnership must pay the imputed underpayment amount (along with penalties and interest) resulting from an IRS audit — unless it makes the 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. This would require all partners to file amended tax returns.
As the name suggests, 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 in question. 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. The proposed regulations specify the information that must be included in a push-out election. The partnership must also provide affected partners with a statement summarizing their shares of adjusted partnership tax items.
Election to Opt-out for Small Partnerships
Partnership-level audits and collection proceedings are the default for all partnerships, even those with only a few members. However, a partnership with 100 or fewer qualifying partners can opt out by making an annual election on its partnership return. If the partnership opts out, the audit will proceed against each partner separately.
However, some partnerships might not be able to opt out. To opt out, every partner must be a qualifying partner, a qualifying partner is:
- an individual;
- a C corporation;
- an S corporation; or
- an estate of a deceased partner.
A partnership that has other partnerships or trusts as partners will be unable to elect out of the new audit rules. The election must be made annually and must include the name and taxpayer ID of each partner. The partnership must notify each partner within 30 days of making the election to opt-out.
Eligible partnerships may want to amend their partnership agreements to address whether electing out will be mandatory. In most situations, electing out will be preferable. Partnerships choosing to elect out may want to amend their agreements to prohibit the transfer of partnership interests to partners that would cause the option to elect to opt-out to be unavailable. They also may want to limit the number of partners to 100 or fewer to preserve eligibility for electing out.
The new partnership audit rules eliminate the tax matters partner role that applied under the old rules. Instead, partnerships will be required to designate a partnership representative. The partnership representative has the sole authority to act on behalf of the partnership in IRS audits and other federal income tax proceedings.
Under the proposed regulations, the partnership representative has a great deal of authority. Specifically, the partnership representative has the sole authority to extend the statute of limitations for a partnership tax year, settle with the IRS or initiate a lawsuit. Any defense against an IRS action that isn’t raised by the partnership representative is waived.
According to the proposed regulations, partnerships must designate a partnership representative separately for each tax year. The designation is done on the partnership’s timely filed (including any extension) federal income tax return for that year. The partnership representative does not have to be a partner in the partnership.
Partnerships should consider amending their agreements to establish procedures for choosing, removing and replacing the partnership representative. In addition, the partnership agreement should carefully outline the duties of the partnership representative.
Although the new partnership audit rules don’t take effect until next year, partnerships should start reviewing partnership agreements and amending them as necessary. We generally recommend using the opt-out election if available; however, if unavailable we recommend using the push-out election once under audit, but please contact us if you have any questions.