New Partnership Audit Procedures — What Do They Mean for My Partnership or LLC?
Part 1 (Originally Published on April 11, 2017)
Congress enacted new partnership audit rules as part of the Bipartisan Budget Act of 2015 (the “Act”). As outlined further below, these new audit rules make it easier for the IRS to audit and assess tax on entities taxed as partnerships, including general partnerships, limited partnerships, and LLCs. This article is the first of three articles describing the modified partnership audit rules. The IRS issued proposed regulations implementing the provisions of the Act. These proposed regulations were not published due to the regulatory freeze announced by the White House on January 20, 2017.
Why the New Audit Rules for Partnerships?
Prior partnership audit rules (commonly known as the “TEFRA Rules”) prohibited the IRS from assessing tax on a partnership. Instead, to collect tax for partnership items, the IRS was required to examine and adjust the income of each individual partner in a separate proceeding. Congress and the IRS found that these separate audit proceedings often resulted in disparate treatment among partners. Moreover, as partnerships became more complex and multi-tiered, the burden on the IRS increased.
While the number of “large” partnerships (those with more than $100 million of assets and ten or more direct and indirect partners) grew by over 257 percent between 2002 and 2011, partnership audit rates remained low. The audit rate for similarly sized corporations in 2012 was 27.1 percent. The IRS reported that audit rates for large partnerships languished at 0.8 percent. Congress believed that the partnership audit rules hindered the IRS’ ability to effectively examine and assess tax against partnerships.
Said another way, Congress believed the IRS was missing out on available revenue that would be collected if partnerships were taxed as corporations. Thus, it appears likely that the IRS will use the new rules to more actively audit partnerships than in the past.
What Are the Major Changes to Be Aware of?
The new partnership audit procedures make three major changes that we believe are noteworthy:
- Centralized Audit, Adjustment, and Collection. The new rules allow adjustment of partnership items to cause tax to be assessed and collected against the partnership, rather than the individual partners. For the first time, the IRS can make adjustments, assess tax, and take collection action against partnerships at the entity level. We will provide more details on this in Part 2 of this article, which will be coming soon.
- New Partnership Representative Rules and Responsibilities. The new rules amend the provisions regarding who can act on behalf of and bind the partnership in audit proceedings. The new partnership representative that would act in proceedings with the IRS now has much more responsibility for tax matters of the partnership. We will discuss considerations in naming a partnership representative in Part 3 of this article, which will be coming soon.
- New “Opt Out” Provisions. New rules and procedures apply to determine when a partnership can “opt out” of the new audit rules.
Given that Congress has provided a clearer path for the IRS to collect revenue against partnerships, we believe partnerships (and, in particular, large partnerships) will see more audit activity in 2018.
What Should Partnerships Do Now?
The new partnership audit rules take effect January 1, 2018. Many partnerships established under the TEFRA rules should consider taking the following steps to minimize potential audit exposure:
- Name a Partnership Representative. Existing partnerships should name a new “partnership representative” (similar in some ways to the “tax matter partner”) to work with the IRS if the partnership is audited. Failure to do so could lead to the IRS choosing the partnership representative.
- Review Partnership and Operating Agreements for Compliance. It would be worthwhile for partnerships and LLCs to review existing partnership and operating agreements to ensure that applicable tax provisions have “substantial economic effect.” This would include review of capital account maintenance, qualified income offset, minimum gain chargeback, and liquidation provisions to ensure compliance with applicable regulations.
- Review Provisions that Could Result in Additional Self-Employment Tax or Compensation. Partnerships and LLCs should review records to ensure that they minimize self-employment tax to partners and members. In addition, care should be taken to alleviate the risk that partners rendering services to partnerships, especially those receiving capital interests in the partnership or LLC for services, could be subject to compensation treatment.
Performing some basic due diligence prior to audit could put your partnership or LLC on much more solid ground in the event an agent that is freshly trained in auditing partnerships comes calling.
What Effect Does the Regulatory “Freeze” Have on These Rules?
Because the new partnership audit rules are statutory in nature, the announced regulatory “freeze” should not have a significant effect on the new audit rules. While final regulations will need to be published, we believe the IRS will use the unpublished proposed regulations as a guideline for audits under the Act.
Part 2 (Originally Published on August 2, 2017)
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.