Authored by: Jose A. Paz, Manager
The Bipartisan Budget Act of 2015 (the “2015 Budget Act”) signed by President Obama on November 2, 2015 includes provisions that significantly change the rules for partnership audits, making the process easier for the Internal Revenue Service to audit and collect taxes from partnerships.
Currently, there exist three different regimes for auditing partnerships dependent mainly on the number of partners:
Most partnerships today are subject to the TEFRA rules, which are quite cumbersome for the Internal Revenue Service (“IRS”) to administer. Under TEFRA, the IRS conducts audits of partnership items at the partnership level and imposes any liability for such audit adjustments on each partner individually. Therefore, the collection of the liability proves to be quite difficult for the IRS—especially for partnerships with many partners. This administrative burden is more than likely the main contributing factor to the very low audit rate for partnerships compared to other taxpayers. The 2015 Budget Act repeals this current system and replaces it with one set of rules.
To simplify the collection process, one of the significant changes in the new law is that the partnership is liable for any federal tax deficiency resulting from the audit rather than the partners themselves (unless the partnership can avail itself of an elective alternative as discussed below). The tax liability associated with audit adjustments will no longer be assessed and collected at the partner level. This deviates dramatically from the long-standing concept of treating partnerships as entities not subject to income tax.
Upon completion of the audit, the adjustments are netted and multiplied by the highest marginal U.S. federal income tax rate (currently 39.6% for individual taxpayers) to determine the “imputed underpayment.” The imputed underpayment is assessed against the partnership in the year the audit is finalized. The partners in the partnership at that time bear the cost of such liability even if they were not partners in the year subject to the audit.
For example, if the tax year under review is 2018 but the imputed underpayment is not assessed until 2021, the partnership pays the tax with its 2021 tax return and those partners bear the cost. Also, any interest associated with the underpayment is not deductible by the partnership.
Furthermore, in the event that the adjustment relates to a reallocation of partnership items among the partners (not any net increase or decrease of total partnership income), the imputed underpayment takes into account the net increase in income to one partner but does not consider the corresponding net decrease to the other partner. Consequently, this may result in the double taxation of income.
The partnership may elect to have adjustments from an audit passed through to the partners by issuing revised Schedule K-1s to such partners. The obligation to file amended returns and remit the tax liability passes from the partnership to the partners.
Electing to pass through the adjustment to the partners has several benefits for the partners. First, the amount of the imputed underpayment is determined at the partner level and therefore, the partner can take into consideration its own tax attributes and its marginal tax rate (as opposed to the highest marginal tax rate). Also, the revised Schedule K-1s are issued only to the partners who were partners during the year under audit. Consequently, this method does not transfer the economic burden of the imputed underpayment to partners who were not parties to the economic agreement in the year under audit.
Ironically, this method mirrors the current regime in that the IRS bears the administrative burden to ensure that each partner pays the imputed underpayment. It would not be surprising (or inconsistent with the overall “theme” of the legislation) if subsequent guidance is issued requiring the partnership to pay in the event the partners fail to file and remit the additional tax due.
Partnerships can elect out of these audit rules if they have less than 100 partners and the partners consist of individuals, C corporations (or foreign equivalents), S corporations, or an estate of a deceased partner. Therefore, any partnership that has a partnership as a partner (i.e., tiered partnership structures) cannot elect out. This election to opt out must be made each year.
Partnerships will designate a ‘partnership representative,” who does not have to be a partner, instead of a tax matters partner. The only requirement is that the representative has a substantial presence in the United States. The representative will have sole authority to bind the partnership and all its partners with respect to audit or litigation proceedings.
Furthermore, since the new rules do not include a “notice partner” only the partnership representative and the partnership itself will be notified of any proceedings. Consequently, partnerships should carefully consider who to designate in this capacity as well as liability protection for actions performed as a representative.
The new audit rules apply to taxable years beginning on or after January 1, 2018. Although the effective date is more than two years away, partners should be thinking about possible amendments to their partnership agreements to account for these new provisions. Specifically:
One likely outcome of this new legislation is an increase in audits of entities taxed as partnerships. Therefore, partners should start planning now to prepare themselves for the changed landscape ahead.
The True Partners Consulting’s pass-through team is available to advise clients on the new partnership audit rules and how it may affect your partnership in the future. Please contact any one of our team members below to address your questions or concerns.
Download this article.