The Bipartisan Budget Act of 2015 (BBA) changed how partnerships are audited. Proposed IRS rules for partnership audits under the law apply to taxable years beginning after December 31, 2017, but some partnerships can choose to opt out. If your business is organized as a partnership, here’s what you need to know.
New audit rules
The proposed regulations provide a default audit regime under which the IRS will assess tax on any tax adjustment that increases a partnership’s income against the partnership itself, instead of against the individual partners from that tax year. In other words, the economic burden will hit the partners in place when the audit adjustment is finalized, not those in place during the tax year that income was underreported.
Alternatively, a partnership can elect to “push out” the adjusted items to the partners from the relevant tax year. Those partners would take their shares of the adjustments into account on their individual tax returns. (Separate proposed regulations provide rules addressing how partners that are pass-through entities, such as limited partnerships or limited liability companies, take into account pushed-out adjustments.)
The proposed regulations for partnership audits also create the new role of partnership representative (PR). This person replaces the tax matters partner under the former regulations.
The PR has sole authority to act on behalf of the partnership. He or she wields broad authority to bind the partnership and all partners, including the ability to waive the statute of limitations, proceed to litigation and make the push-out election — all without any duty to communicate with the partners regarding an audit. And if the partnership fails to designate a PR, the IRS has the power to do so.
Thus, choosing a PR is very important, so businesses should review how the partnership agreement covers this role and make any necessary amendments. Because the PR has more authority than the former tax matters partner, simply doing a “global replace” in the partnership agreement isn’t enough. Remember, the IRS will be dealing solely with your PR, so it may be prudent to require in the agreement that that person notifies all partners of any communications he or she does have with the IRS.
The BBA generally allows certain partnerships to opt out of the BBA rules entirely. This means they and their partners would be audited under the rules applicable to individual taxpayers. If a partner is a partnership or limited liability company, though, the overall partnership can’t elect out of the rules.
In early 2018, the IRS issued final regulations that clarify which partnerships can opt out and how. They provide that partnerships with 100 or fewer qualifying partners can opt out as long as the partners are:
• C corporations,
• Foreign entities that would be treated as C corporations if domestic,
• S corporations, or
• Deceased partners’ estates.
Eligible partnerships must furnish 100 or fewer Schedules K-1, “Partner’s Share of Income, Deductions, Credits, etc.” Spouses count as two partners, and persons who hold a partnership interest on behalf of another person don’t qualify as eligible partners. If an eligible partner is an S corporation, the S corporation’s shareholders are taken into account when determining whether the partnership must furnish 100 or fewer statements, as is the statement issued to the S corporation itself.
Eligible partnerships that wish to opt out should make the election on their timely filed tax returns for the tax year to which the election applies. Elections are irrevocable without IRS consent. Partnerships must notify each partner of the election within 30 days of making it, using the form and manner the partnership chooses.
The election must include each partner’s name, tax identification number and federal tax classification. In addition, the partnership must include an affirmative statement that the respective partner is an eligible partner, along with any additional information the IRS requires in forms, instructions or other guidance. If an eligible partner is an S corporation, the partnership must provide the name and Social Security number of every shareholder in the S corporation.
If the IRS determines that an election is invalid, it will notify the partnership in writing. The new partnership audit procedures will apply, and any adjustments and penalties will be collected at the partnership level.
Merely being eligible to opt out isn’t reason enough to do so — your business could have good reasons to stick with the new audit regime. And it’s worth noting that the IRS has made clear that opting out won’t reduce the likelihood of audit. Give us a call to determine the best course forward for your circumstances.