The IRS will begin a new way of auditing partnerships and LLCs (as most are treated as partnerships) for tax years beginning after Dec. 31, 2017. With these new rules comes the potential for a host of new disputes among partners.
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Various strategies for mitigating effects of the changes will require cooperation from partners who may not be compelled to work together. Partnerships need to develop a roadmap before venturing into this new frontier. Like going to the dentist, an update to the partnership agreement may be a dreaded but necessary task to provide for this roadmap.
In this article, I outline the basics of the new rules, their impact on partnerships and actionable steps businesses can take now to prepare.
A brief history of partnership audits
Since 1982, the IRS has audited partnerships under the Tax Equity And Fiscal Responsibility Act (TEFRA) by making adjustments to partnership items, and then generally determining and collecting tax deficiencies from (or issuing refunds to) the affected partners. As the complexity of ownership structures has grown, so have increasingly imaginative partner profit-sharing strategies, which has diminished the practical ability of the IRS to audit partnerships.
The Bipartisan Budget Act of 2015 repealed the current TEFRA procedures and special rules relating to electing large partnerships. The new rules establish audit procedures that apply to all partnerships. Now, the default rule will be that underpaid taxes, penalties and interest will be assessed against and collected directly from the partnership.
This was done with multiple goals in mind. First, the rules will simplify the role the IRS plays in administration of partnership audits. Second, the rules are intended to solve the disparity in audit rates between partnerships and other business forms. For example, according to a 2014 report issued by the U.S. Government Accountability Office, the IRS audited less than 1 percent of 2012 income tax returns of large partnerships, and two-thirds of those large partnership audits resulted in no changes. By contrast, over 27 percent of large C corporation tax returns in 2012 were audited, where only a quarter resulted in no changes. So, one of the goals of the new audit rules is to level the playing field, and the rules are expected to raise an additional $9.3 billion in tax collections over the next 10 years.
Key changes proposed under the new rules
Starting in the 2018 tax year, the IRS will collect tax deficiencies, penalties and interest by default from the partnership during the year an audit concludes. The maximum rate of tax in effect for any type of taxpayer will be used to calculate the tax deficiency (for example, the current maximum rate would be for individuals and the rate is 39.6 percent). All partnerships are subject to the new rules by default.
Non-positive (favorable) adjustments do not result in refunds to the partnership. These are captured as income adjustments on the partnership’s tax return to be filed for the year during which the exam concludes.
Partnerships must designate a partnership representative. The partnership representative will be the sole person with whom the IRS will communicate audit-related notifications. The partnership representative will have unilateral authority with the IRS to bind the partnership and the partners to decisions affecting them. He or she has no statutory duty to involve the partners in partnership audit decisions.
The partnership’s liability can be modified in several ways. The partnership representative can request that a lower rate be used to compute a liability, if a lower maximum tax rate would apply at the partner level. The partnership representative can also use varying procedures to shift the tax responsibility for exam adjustments onto the partners, thereby reducing (or eliminating) the partnership’s liability for such.
Eligible partnerships can elect to opt out of the new rules. Eligible partnerships are those that do not have any partners classified as partnerships, trusts (including grantor and revocable trusts), disregarded entities, foreign entities that would not be classified as corporations had they been domestic, nominees and estates not belonging to former partners. Eligible partnerships must also issue 100 or fewer Schedule K-1s. Shareholders of S corporation partners count toward this Schedule K-1 limit.
How partnerships can prepare
The partnership’s liability for audit adjustments places the economic burden on the current partners during the year the exam concludes, regardless of whether they are the same persons or entities that were partners in the tax year being audited. Modification strategies can be used to change this result, but they often will disadvantage the prior partners in favor of the current partners or vice versa. Considering the level of authority the partnership representative has to implement these strategies, contentious situations could emerge between the partners or with the partnership representative.
Also, certain modification strategies may not be available unless partner data is available on a timely basis. Many choices will be complex and require lengthy analysis to determine which is the most desirable. Further, an opt-out election subjects the partnership and the partners to separate audits of the partnership and each individual partner, potentially creating disparate treatment among the partners.
A revised partnership or member agreement is the only way to contractually address and diffuse these potential issues before they arise.