New partnership audit rules became effective for tax years beginning on or after January 1, 2018. The rules are applicable to partnerships and limited liability companies that are taxed as partnerships. The rules not only change the method under which the IRS audits partnerships but also introduce administrative provisions and elections which can have significant economic impact on the partners.
Under the previous “TEFRA“ audit regime, while the IRS might conduct an audit with the partnership, audit adjustments flowed through to the partners, who became responsible for the tax liability. Under the new rules, the audit will be handled at the partnership level and all partnership items will be determined at the partnership level. Neither the IRS or the partnership will be obligated to notify partners with respect to the audit exam or keep them updated. Unless the partnership determines to “push out” the tax obligation to the partners, the partnership is obligated to pay any underpayment deficiency amount, including interest and penalties, calculated on the highest individual tax rates. The partnership tax liability is for the partnership year that the audit is completed and not the year under review.
The partnership obligation can be reduced if the partners file amended returns and pay additional taxes individually or if partners are tax exempt or taxed at lower rates on certain income. However, unless the deficiency adjustment is pushed out by the partnership, the payment occurs at the partnership level and is born by the current partners under the provisions of the partnership agreement.
Partnership Representative. One of the most significant changes under the new rules is the replacement of the tax matters partner with a “partnership representative”. Unlike the TEFRA rules, the partnership representative may be an individual or an entity and does not have to be a partner. The partnership representative is appointed for each year on a timely filed partnership return. The partnership representative has substantial authority and can bind both the partnership and the partners in administrative proceedings and judicial actions relating to the audit. Partners do not have the ability to appeal the decisions of the partnership representative. Instead, they are generally required to report in a manner consistent with items reported and allocations made at the partnership level.
The partnership representative has the sole authority to bind the partnership in connection with the audit, including any settlement determinations. The partnership representative may also make the election to push out the tax underpayment liability to the partners and the election to elect out of the new partnership audit regime if the partnership is qualified to make such an election.
Push-Out Election. Instead of having an underpayment adjustment assessed at the partnership level, the partnership representative may elect to push out the liability to the individual partners. The push out election can apply to all or less than all the proposed underpayment adjustments. After making the election, the partnership is required to provide a written statement to the IRS and each partner as to each partner’s allocable share of income, gain, loss and other adjustments. The partners report their additional tax, interest and penalties in the year they receive the notice of adjustment from the partnership.
The push out election not only transfers the obligation for the liability to the partners but it also may change the partners who are obligated to pay. When the deficiency is payable at the partnership level, it falls economically on the current partners. The push out election transfers the liability to the partners for the tax year under audit. This may be a different group of partners with different percentage interests.
Election Out. Eligible partnerships may elect out of the new audit rules on a timely filed partnership tax return. To be eligible, the partnership must have 100 or fewer partners and all of the partners must be “eligible partners“ at all times during the taxable year. An eligible partner is an individual, a C corporation, an S corporation, the estate of a deceased partner, and certain foreign entities. Thus, a partnership cannot elect out if any of its partners are partnerships, trusts, disregarded entities, nominees and estates other than for a deceased partner.
Partnership Agreement Amendments. The new rules do not require an amendment to the partnership or operating agreement. However, because the new regime can have a significant impact on the determination of tax liabilities and the parties who bear them, many partnerships will want to amend their agreements to add specific limitations and procedures. These may include:
- Procedures for appointing and replacing the partnership representative.
- Limitations on the powers that may be exercised alone by the partnership representative and notice requirements to the partners.
- Whether the partnership should always or never make an opt out election or a push out election to the partners.
- How partnership tax liability should be allocated to the partners under these procedures and the effect on capital and distributions, including possible provisions for corrective allocations, distributions or capital calls.
- Obligating partners to provide information to allow the partnership to modify its tax adjustments when the liability is incurred at the partnership level.
- Obligating audit year partners to pay for audit adjustments even if payment is made at the partnership level.
- Indemnification provisions for the partnership representative.