The New IRS Partnership Audit Rules – Significant Changes on the Horizon Require Attention
Written by Steven N. Smith, CPA, JD
The Bipartisan Budget Act of 2015, enacted on November 2, 2015, includes significant changes in IRS rules regarding the tax examinations of partnerships. The new rules are generally effective for partnership taxable years beginning after December 31, 2017, but early application of the rules may be elected by partnerships for years beginning after November 2, 2015. Even if a partnership does not elect early application, partnerships and partners should be closely examining their partnership agreement (or operating agreements in the case of limited liability companies taxed as partnerships), and sooner rather than later.
The new rules replace the existing partnership audit guidelines that have been effective since the passage of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). The legislation is rather complex and grants the IRS significant regulatory authority to work out the details.
The new rules are different in many respects, but perhaps one change is most noteworthy, and provides the most potential for unpleasant surprises to uninformed partnerships and their partners – past, present and future. Generally, under the new rules, any adjustment to items of income, gain, loss, deduction, or credit of a partnership for a partnership taxable year (and any partner’s distributive share thereof) shall be determined, and any tax attributable thereto shall be assessed and collected, at the partnership level, rather than passing through to the individual partners for the tax year adjusted.
Let that last phrase sink in for a moment…. When the tax is assessed and collected at the partnership level, the current partners of the partnership, without any binding agreements to the contrary, will bear the economic burden (or benefit perhaps) of the tax assessment, even though it is possible that they might not have been a partner in the year under examination. Furthermore, a former partner during the year under examination will generally bear no economic burden of the tax assessment, without any binding agreements to the contrary.
Under the rules, the IRS will assess the partnership in the year the adjustment is made, rather than the tax year that was under examination. The imputed underpayment will generally be taxed at the highest individual rate. Under its broad regulatory authority, however, the IRS may establish rules that could adjust this rate if the partnership proves that partners are subject to a lower rate.
Partnerships with 100 or fewer partners may annually elect out of the new rules if the partners are individuals, C corporations, S corporations, decedents’ estates, and foreign entities that would be treated as C corporations if they were domestic entities. Thus, if any of the partners are other partnerships or trusts, an election out is not permissible. Also, for the 100 partner limit, shareholders of S corporation partners are treated as partners in the underlying partnership.
Another change under the new laws is that the concept of a tax matters partner will be replaced with a partnership representative, who will have the sole authority to act on behalf of the partnership. The partnership and all partners are bound by the actions taken by the partnership representative.
As mentioned, these new rules are very complex and a complete summary is beyond the scope of this communication. Partnerships and partners, however, should become educated on the complexities before they are effective and consider possible modifications to existing partnership agreements, and the desired provisions in new agreements to reflect the new rules and protect the interests of partners and partnerships. These provisions should necessarily include the ramifications of transfer of partnership interests under these rules.
Possible drafting considerations include, but are not limited to:
- Should the partnership agreement and transfer of partnership interest agreements include indemnification or other provisions to address tax liabilities arising from prior year examinations impacting future years;
- The selection of Partnership Representative, including the clarification of rights or restrictions on those rights, within IRS limits; and
- Procedures for deciding how and when the partnership should make an annual election out of the assessment at the partnership level.
Such actions as those listed above and others will make the tax adjustments and /or payments of tax arising from an IRS examination of a partnership, a more predictable situation for the partners and the partnership, minimizing unintended circumstances. If you would like to discuss these new rules further, please contact your BMSS professional at (205) 982-5500 or visit our website at www.bmss.com.
Written by Steven N. Smith, CPA, JD