New Partnership Audit Procedures — What Do They Mean for My Partnership or LLC? (Part 2 of 3)
This is the second of a three-part overview of the new partnership audit rules codified in the Bipartisan Budget Act of 2015 (the “Act”) that will take effect January 1, 2018. In Part 1, we provided an overview of the new partnership audit rules. In this Part, we describe the mechanics of the single most important change imposed by the new partnership audit rules—the ability of the IRS to assess and collect tax at the entity level rather than at the partner level. We also describe a special election that the partnership can make to “push out” tax liability to partners.
Basic Rule—Partnership “Imputed Underpayments”
Under new Section 6225 of the Internal Revenue Code, adjustments of a partnership’s items of gain, loss, deduction, and credits are aggregated (under grouping and netting rules set forth in the Proposed Regulations) . If the adjustments result in additional items of gain (creating income), that income is assessed against the partnership, at the partnership level. Thus, the partnership pays any tax liability assessed against it, even if the tax is attributable to a year in which ownership of the entity was different!
What Tax Rate Applies to an Imputed Underpayment?
The imputed underpayment is multiplied by a rate equal to the highest rate imposed on corporations or individuals for the reviewed year. The partnership can lower the rate by demonstrating that a lower rate should apply. For example, if a portion of the partnership interests were owned by a C corporation (rather than an individual), a lower rate could apply. The new rules may also allow a reduced rate for amount attributable to a tax-exempt entity.
Example: ABC, LLC is taxed as a partnership. Items of income are allocated as follows:
- 1/3 to Charity, an organization exempt from income tax under IRC section 501(c)(3);
- 1/3 to Corporation, which is taxed as a C corporation; and
- 1/3 to Joe, an individual.
The IRS audits the partnership and finds an imputed underpayment of $100,000. The highest rate for corporate and individual rates is 39.6 percent. The IRS assesses tax of $39,600 on ABC, LLC.
The partnership requests an adjustment for the income attributable to Corporation because the highest C corporation rate for the year is 35 percent. The partnership can request that the rate attributable to Charity to be lowered as well, so long as it can show that the income is not “unrelated business taxable income” or otherwise taxable. Accordingly, the tax imposed would be as follows:
- $33,333 x 0.00 = $0 tax attributable to Charity.
- $33,333 x 0.35 = $11,667 tax attributable to Corporation.
- $33,333 x 0.396 = $13,200 tax attributable to Joe.
- TOTAL: $24,867
Timing Problems—”Reviewed Year” vs. “Adjustment Year”
One of the most obvious problems associated with the new partnership audit rules is a problem of timing. The partnership will be assessed income for any “reviewed year.” A “reviewed year” is any year that is open for audit. On the other hand, the payment takes place in the “adjustment year.”
Example: ABC, LLC is audited in 2020 for the tax years 2018 and 2019. 2018 and 2019 are the “reviewed years.” The IRS asserts an imputed underpayment of $100,000. Under the general rule, ABC, LLC will be responsible for paying the tax relating to the imputed underpayment in 2020 (the “adjustment year”).
This means that the partners in the adjustment year bear the brunt of the imputed underpayment, even if they were not partners in the reviewed year. Unless the partnership or operating agreement requires a “push-out” (see below), the adjustment year partners may end up bearing the burden of any adjustments for the reviewed years.
Despite the general rule that the partnership pays for any additional tax, IRC section 6226 allows a partnership to elect to pass through (or “push out”) any adjustments to the partners. If the partnership makes this push-out election, the adjustments will be pushed out to the partners for the reviewed years, rather than being paid by the partnership. This election would effectively cause the partners who received the tax benefit to bear the burden of a subsequent adjustment. But the push-out election would generally only be available where the partnership or operating agreement of the partnership provides for it. This means that if the partnership desires to utilize this election, it should amend its partnership or operating agreement to require the election.
Because of the many disadvantages involved with the new partnership audit rules, many entities taxed as partnerships will want to elect out of the regime. In Part 3, we will outline what entities are eligible to elect out.
The new partnership audit rules generally provide that a partnership will now be responsible for tax for which its partners would have been responsible under the previous rules. LLCs and partnerships should carefully review their governing documents to ensure that the “business deal” is kept intact despite the new rules.