Over the past many years, Congress has grown concerned about the low audit rates for partnerships. In recent years, the Department of Treasury and the IRS have been discussing how to facilitate easier and more streamlined partnership audit rules. The signing of the Bipartisan Budget Act of 2015 issued in sweeping changes to the partnership audit rules for partnership tax years beginning after December 31, 2017. The changes include a repeal of the current Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”) partnership audit rules. The new partnership audit rules are a drastic change from the TEFRA rules and will impact virtually every partner agreement and transaction.
Although the framework of the new partnership audit rules are included in the set of rules for auditing partnerships in the new Internal Revenue Code Sections 6221 through 6241, the IRS is going to be relied upon to clarify and issue procedures and guidelines. It is not clear when the procedures and guidelines will be available. There are a few features to the new rules that have been brought forth described below.
New Partnership Entity-Level Tax
The new audit rules would examine the partnership’s items of income, gains and losses. If any changes are made to the partnership’s income, gain or losses, the IRS would assess the partnership for any additional tax required. The tax would be computed at the highest marginal tax rate in effect for the year examined and will not take into consideration any partner-level tax attributes.
The new audit rules do allow for the partnership to make an election for the audit adjustments to be paid at the partner level. The election must be made no later than 45 days after the date of the issuance of the notice of final partnership administrative adjustment.
The new rules were put in so quickly from provisions proposed by Rep. James Renacci, (R-Ohio) that there was no opportunity to hold additional hearings to refine and clarify the new rules. Consequently, the resulting tax liability that may be imposed on the partnership may have a different financial impact to the current partners, as opposed to the partners that were in the partnership for the period that was subject to audit. It has also not been addressed as to who pays the tax in the review year if the taxpayer no longer exists or is deceased at the time of the adjustment year.
Barring any apparent benefit to not making the election for audit adjustment to be paid at partner level, it should be a matter that the partnership and its partners address either in the drafting of the new partnership agreement or amending a current partnership agreement to address the issue.
Small Partnership Exception
The small partnership exception allows the partnership to opt-out of the new audit rules for partnerships; instead, the partnership will be audited under the general rules applicable to taxpayers. In order to opt-out of new audit rules, the partnership must elect to do so every year. Eligible partnerships must meet the following criteria 1) have 100 or fewer Schedules K-1 a year, or 2) only have individuals, C corporations, S Corporations, or an estate of a deceased partner as partners. Partnerships that have another partnership as a partner cannot opt-out of the new partnership audit rules.
Out with the old “Tax Matters Partner.” In with the new “Partnership Representative.” The new Partnership Representative concept is a drastic change from the Tax Matters Partner. The Partnership Representative does not need to be a partner in the partnership. He/she will also have broad authority to resolve any partnership audit with binding authority on actions of the partnership and all of its consequences to the partners.
With these new powers in mind and given that the new rules do not give partners any statutory right to notice of, or participation in, the audit proceedings, it is advised that partners should negotiate the designation and the specific powers granted to the Partnership Representative in the partnership agreement. This must be done through an amendment to the current partnership agreement or when drafting a new agreement.
These new partnership audit rules are considered to be a revenue raiser for the federal budget. It is anticipated that partnership return audits will increase drastically given the repeal of the current TEFRA rules in tax years beginning January 1, 2018 and later. The new rules impose a tax at the partnership level unless the Partnership Representative elects to have audit adjustments paid at the partner level.
Actions should be taken by the new partnership in drafting the partnership agreement that addresses the designation of the Partnership Representative and the representatives’ powers. The new partnership agreement should also address the election to have the tax calculated at the partner level if appropriate.
It is also advised that existing partnerships that are having any amendments to their current partnership agreement address these new audit rules in their amendment. As we draw nearer to the implementation date of the new rules, existing partnerships should discuss whether amendment to the current partnership agreement is necessary.
As clarifications of the new partnership audit rules are determined and any revisions are provided, partners should be made aware of such by the Partnership Representative.
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Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.