December 12, 2017
By Matthew Diment, Senior Manager
Long have partnership audits been a thorn in the IRS’ side. Partnerships can have multi-tiered complex ownership structures that can make the final taxpayer difficult to find. Because of this, the audit rate for large partnerships is less than 1%, as compared to over 27% for large corporations. To address this, proposed regulations were issued in June of this year to change the way that partnerships are now audited. These regulations become effective on January 1, 2018.
Prior to 1982, all partnership audits were conducted at the partner level rather than the partnership level. The assessment and collection was done at the partner level as well. In 1982, the Tax Equity and Fiscal Responsibility Act (TEFRA) was passed. Under TEFRA, the audit was typically conducted at the partnership level. Assessment and collection continued to occur at the partner level.
Under the new regulations, scheduled to become effective January 1, 2018, the default position for the IRS will be to conduct the audit as well as assess and collect entirely at the partnership level. Generally this will be at the highest individual tax rate. Certain qualifying partnerships will have the ability to opt out of this treatment, if so desired, and be treated under the pre-1982 rules. To qualify for opt out, the partnership must have fewer than 100 partners and no partner can be an LLC, partnership, or trust. This includes single member LLCs and grantor type trusts. The opt out election must be made annually on the partnership’s timely filed tax return.
Once under audit, if the partnership has chosen not to opt out, there are still some additional options for how adjustments are paid. If the partnership pays for any adjustments made under audit, the current partners bear the responsibility for the year under audit, whether they were partners at that point in time or not. Alternatively, the partnership can choose to push out the adjustments. With this option, a current special K-1 reporting the additional tax, penalty, and interest goes to the partners for the year under audit. Under this option, the partnership will be responsible for contacting those partners receiving the special K-1. A third option is for all partners for the year under audit to amend their prior tax returns within a specified time period. Under these last two options, the partnership may be asking former partners to make payments.
In addition to how partnership audits are conducted, there was another major change under the new rules. Previously partnerships designated a tax matters partner. This was the partner who bore the responsibility of ensuring that the tax returns were filed, providing tax information to the other partners, and managing any audit process. Under the new rules, the tax matters partner has gone away and has been replaced with the partnership representative. The partnership representative is designated every year on the filed tax return and need not be a partner. The partnership representative is the sole point of contact with the IRS in an audit and is not required, unless directed under the partnership agreement, to inform partners of any actions taken during the audit. This includes the determination of who will be responsible for payment of any additional tax, penalties, or interest assessed based on the options available under the new rules.
Because of the significance of the changes being made to the partnership audit rules, it is anticipated that most partnerships will need to make at least some if not significant changes to their partnership agreements. For additional details on how these regulations will affect your partnership, you should contact your legal and tax professionals.