For tax years beginning January 1, 2018 and thereafter, new rules for IRS examinations of partnerships will apply under the Bipartisan Budget Act of 2015 (the “BBA”). The BBA makes a drastic change to the manner in which partnerships are examined, by making a partnership liable to pay Federal income tax for the first time. Due to the complex nature and multiple tiers of many partnerships, under the previous audit rules the IRS has often had to look through numerous partnership layers to collect tax from the ultimate owner. Title XI of the BBA was written to raise revenue by streamlining the IRS’s partnership audit and collection process.
Generally, under the new partnership audit rules, the IRS would examine the partnership’s items of income, deduction, and partners’ distributive shares for a particular year of the partnership (the so-called “reviewed year”). Any adjustments would be taken into account by the partnership, not the individual partners, in the year that the audit is completed (the so-called “adjustment year”). The BBA allows partnerships with eligible partners that issue 100 or fewer Schedules K-1 to elect out of the new audit regime. It is important to note that the ability to elect out is not available to partnerships which have a trust or a partnership as a partner.
Additionally, there are special look through rules when determining whether the partnership issues 100 or fewer Schedules K-1. Since the BBA’s new partnership audit rules are in place to make it easier for the IRS to audit and collect, it is often challenging to meet the requirements to elect out. It is important to review the current organizational structure as well as the possibility of restructuring, (if appropriate in a legal context), in order to be able to elect out of the new rules.
It is imperative for partners to be proactive with their partnership agreements due to the new rules. Partnership agreements should be amended prior to January 1, 2018 to outline how a future partnership audit will be addressed. Partnership agreements should address the ability of eligible partnerships to elect out, as well as their ability to push the payment of the partnership liability to the partner level. The partnership agreement should also disclose the manner in which the payment of tax will be funded and shared among the partners. There may be situations when a partner existed during the “reviewed year” but is no longer a partner during the “adjustment year”. This has the potential for the partnership to incur a tax liability on behalf of a former partner. Therefore, it is important to include indemnity and claw back provisions into the partnership agreement.
Additionally, the new rules require the partnership to designate a partnership representative, which will replace the tax matters partner. The representative must have significant presence in the United States and can be a partner or non-partner. The personal representative will have sole authority to bind the partnership on decisions related to these new partnership audit rules and elections. Every partnership should update their partnership agreement to establish procedures for appointing, replacing and operating with the partnership representative, as well as providing notice of an IRS exam to the partners.
Navigating the new partnership audit rules can be complex. It is recommended that you consult your tax advisor to discuss the implications to your partnership as well as amend your partnership agreements prior to January 1, 2018. To discuss this or related topics, contact your engagement team at DGC. Alternatively, contact Jonathan Farrell, CPA at 781-937-5373/ firstname.lastname@example.org or Kara Cefalo, CPA, MST at 781-937-5140/ email@example.com