For 35 years partners have paid taxes and penalties resulting from partnership audits. But the proliferation and increasing complexity of partnerships (including most LLCs) coupled with decreasing IRS staff have made it challenging for the IRS to effectively audit these entities. The Bipartisan Budget Act of 2015 stands to change that, creating new IRS audit procedures beginning with the 2018 tax year.
Currently, the IRS audits “large” partnerships under one of two regimes: unified audit rules from the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) or electing large partnership (ELP) rules from the Taxpayer Relief Act of 1997.
- Under TEFRA, the IRS audits partnerships with more than 10 partners (or less than 10 if one partner is a flow-through entity) throughout the tax year at the partnership level. Once the adjustment is determined, the IRS recalculates the tax liability of each and every partner from the year under audit and collects from those partners.
- With the ELP rules, partnerships with 100 or more partners can elect to be audited at the partnership level. Any tax imposed as a result of an audit is assessed to the partnership as a whole, but tax liabilities flow through to the partners (aka they amend their own returns) in the year the adjustment takes effect — rather than in the audit year. However, very few partnerships have elected to opt in.
Both regimes have proven burdensome as well as ineffective for the IRS. Whether under TEFRA or ELP rules, partners, not the entity itself, historically have been responsible for paying tax liabilities. But the increased number, size and complexity of LLCs and partnerships over the years have made it nearly impossible for the IRS to audit these entities, determine the identity of partners and collect the tax.
Out with the Old
The Bipartisan Budget Act of 2015 repeals ELP and TEFRA rules, opting for one streamlined set of IRS audit procedures. For tax years beginning after December 31, 2017, all partnerships, regardless of size, will be subject to these new rules.
In general, any additional tax, penalties and interest as a result of an IRS audit will be assessed and paid at the partnership level and treated as a non-deductible expense. Instead of altering potentially hundreds of returns for one audit, the IRS will only have one entity to work with and hold responsible. This represents a big change for partnerships, and an even bigger opportunity for the IRS to conduct more partnership audits in the near future.
Some partnerships may be able to elect out of these new audit rules, placing tax liabilities back on individual partners; however, the election comes with stringent rules. The partnership must have 100 or fewer partners who are either individuals, C Corporations, S Corporations or estates of deceased partners. To get a true count, partnerships must “look through” to their partners, because things aren’t always as they appear. For example, you may have 50 partners and believe you can elect out. But, if one of the partners is an S Corporation with 75 shareholders, for purposes of these rules, the partner count is actually 125.
Partnerships that choose to elect out must do so every year on a timely filed return; must notify all the partners of the election; and must disclose certain information to the IRS, including the name and taxpayer identification number of each partner and shareholder of each S Corporation partner.
One of the biggest eligibility requirements for electing out is that a partnership cannot have another partnership as a partner. Partners who are partnerships in their own right add a layer of complexity the IRS doesn’t want to deal with when assigning ultimate responsibility for who’s going to pay the tax bill. If opting out isn’t an option, a partnership also can consider a push-out election to shift the burden to individual partners.
Other Pressing Matters
The impact of the new rules is far reaching. Under TEFRA, the tax matters partner handled tax issues on behalf of the partnership; he or she is a partner of the partnership who has a personal stake in its success. Under the new rules, the partnership representative will handle matters with respect to IRS audits. The representative need not be a partner and, in turn, may not have the same vested interest.
Perhaps even more importantly, the partnership representative has sole authority to act on behalf of the partnership and bind the partnership and all partners with respect to IRS audits; individual partners have no right to participate in the audit proceedings. So, if some partners would prefer to elect out of these rules, they cannot do so themselves. The partnership representative will make the decision. There is no explicit obligation or consequence that says this person must do what the partners say, unless it is specifically stated in the partnership agreement.
While it may be a difficult role to fill, partnerships should choose a partnership representative wisely and potentially limit his or her powers or require certain decisions to have partner approval. If a partnership hasn’t selected a representative and an audit occurs, the IRS can designate one at their discretion.
The timing of the audit and subsequent liabilities under the new rules also represent a significant departure from the current TEFRA playbook, potentially causing partners of today to pay for sins of the past. For example, a partnership audited for the 2018 tax year is assessed taxes, penalties and interest at the time the audit is completed, which could be one or two years down the road. When tax is finally assessed, the partnership and partners at that point in time will be responsible — even if they weren’t partners during the tax year under audit.
This is a critical distinction. It means that anyone considering buying into a partnership should conduct due diligence on the entity’s past tax activities. Also specifically look to the partnership agreement to determine if the partnership will/can opt out of these rules, if former partners will be responsible for future adjustments, etc.
When (and How) to Act
The Department of Treasury issued proposed regulations in January 2017 to clarify how to implement the new rules. The regulations addressed gray areas, such as modifying partnership adjustments. However, these clarifying regulations were later withdrawn due to President Trump’s freeze of all new and pending regulations. While the tax code is already written into law via the Bipartisan Budget Act, the resulting regulations for real-world implementation may, or may not, change.
Until more guidance is available, there are a few things that can be done now, whether creating a new partnership or managing an existing one:
- Consider keeping the total partner count under 100 (remember to include all partners, counting each shareholder of any S Corporation partners).
- Consider not admitting partners who are partnerships, so the partnership can elect out of the new rules.
- Consider modifying your most powerful tool: the partnership agreement. The agreement may be drafted or amended to include language specifically related to the new rules, such as opt-out preferences, partner liability related to future adjustments and indemnification provisions for new partners.
But one of the most important changes to make to the partnership agreement is in regard to the partnership representative. Remember the partnership representative is the final say when it comes to issues related to IRS audits. The representative can tell the IRS what he wants but cannot ignore the partnership agreement. If he acts beyond his limits as stated in the partnership agreement, he’s in breach.
Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts and circumstances.