New Partnership Audit Rules: Acquiring Partner Inherits Selling Partner’s Audit Risk
Ending over two years of anticipation, the new partnership audit rules are about to go live. On January 1, 2018, regulations will go into effect that make the IRS much more nimble at examining and assessing additional tax, penalties, and interest with respect to partnership returns. It is expected that the new rules will spur on increased audit activity in the partnership area.
Enacted in 1982, the TEFRA partnership audit provisions created a cumbersome system that has long hampered the IRS. In general, the audits have been administered at the partnership level while any resulting changes were required to flow out to the partners as adjustments to their taxable income for the year under examination. Consequent adjustments to tax, take into account the partner’s filing status and tax bracket in the year under review. The Service has borne an arduous task of calculating and collecting additional tax from each of the partners.
Under the centralized audit approach introduced by the Bipartisan Budget Act of 2015 (“BBA”), audits will generally continue to be conducted at the partnership level, but the resulting tax adjustments will be imposed on the partnership. This is a significant departure from flow-through taxation that is fundamental to partnerships. Upon conclusion of an examination, the partnership will be liable for an imputed underpayment which is calculated using the highest rate of tax, currently 39.6%. The upshot is that the partnership will generally pay the tax at a very high rate and pass the cost on to its existing partners, who may be different from the partners whose taxable income was underreported in the year under review. A request for modification of the imputed underpayment may be made within 9 months of the proposed adjustment to take into account the tax-exempt status of some partners and other limited circumstances.
Partnership Representative replaces Tax Matters Partner Each year, on its timely filed return, the partnership will designate a Partnership Representative to represent the entity for that particular tax year. This individual or entity will have exclusive authority to make elections and take actions under the new rules that will bind the partnership and the partners, a far more active and powerful role than the Tax Matters Partner under the TEFRA rules.
“Opt Out” Election An eligible partnership may annually elect out of the new regime on its timely filed return. To be eligible the partnership must have 100 or fewer partners, and each partner must be an eligible partner. For this purpose, the number of partners is increased if a partner is an S corporation; each shareholder in the S corporation is counted as an additional partner in the partnership. Furthermore, the following types of entities are not considered eligible partners: trusts, partnerships, and all disregarded entities, such as grantor trusts and single member limited liability companies. This last distinction severely limits the benefit of this election, as a great many partners own their interests through a living trust or single member LLC.
“Push Out” Election Within 45 days of receiving the Final Partnership Adjustment the Partnership Representative may elect to “push out” the adjustment to the taxpayers who were partners in the year under review, shifting the liability from the partnership to these partners. This election may have profound economic consequences where partners have changed between the year under audit and the year that the additional tax is determined, which highlights the importance of the selection of Partnership Representative. Two cautions about this election: 1) an increased interest rate (+2%) will apply to any assessment and 2) guidelines are still forthcoming as to how the election applies in the case of a tiered partnership structure.
Action Required We strongly recommend that our clients consider the impact of these new rules and amend partnership agreements accordingly before the effective date. As suggested amendments may vary depending on the particular characteristics of each partnership, we urge you to contact us for a more specific discussion. Please reach out to the partner or manager on your engagement. Some things to consider:
- Partners may want to negotiate consultation rights or indemnification with respect to actions taken by the Partnership Representative.
- Transfer restrictions may be helpful to avoid losing the ability to make the Opt-Out election. See above for ineligible partners.
- It may be wise to close complicated transactions before the effective date of the new rules, i.e. by 12/31/17.
- The creation of a partnership-level tax liability may give rise to disclosure on audited financial statements in compliance with ASC 740.