Press Room: Tax Release
Two-Year Budget Deal Provides Streamlined Rules for IRS Audits of Large Partnerships
The Bipartisan Budget Act of 2015 replaces the current rules for partnership audits by Internal Revenue Service (IRS). The new rules impose liability resulting from the audit on the partnership unless the partnership makes an annual election to opt-out.
Under current law, partnerships can be audited under three different regimes: (1) the unified audit rules for TEFRA partnerships, (2) the small partnership rules for partnerships with 10 or fewer partners, and (3) the rules for electing large partnerships. Under these regimes, IRS has to collect the assessed tax at the individual partner level (that is, the partnership does not pay the tax). While IRS may technically audit widely held partnerships (those with many partners), the exams have no teeth because IRS has a limited capacity to assess the tax at the partner level. Due to these complexities, widely held partnerships often escape IRS audit altogether.
New Audit Rules
All partnerships will be subject to the new streamlined audit approach for taxable years beginning on or after January 1, 2018. Under the new rules, the partnership (not the partners) is responsible for any additional tax, penalty, or additional amount resulting from the adjustments made by IRS in the year that the audit or judicial review is complete. The partnership generally must pay a tax equal to the imputed underpayment, which generally is the net of all adjustments for any reviewed year, multiplied by the highest individual or corporate tax rate. Any net adjustments not causing underpayments are taken into account by the partnership and generally flow through to the partners in the year the adjustment is made. The amount of the underpayment at the partnership level is reduced to the extent partners for the year under audit file amended tax returns reflecting the adjustments within 270 days of the time the partnership receives the notice of adjustment.
Partnership Election for Partners to Pay Tax
As an alternative to taking the adjustment into account at the partnership level, a partnership can make an election, within 45 days after a notice of final partnership adjustment, to issue adjusted information returns to the reviewed year partners who must take the adjustment into account through a simplified amended-tax return process. This election will cause the partners for the year that was reviewed to incur the liability (and not the partners for the year in which the assessment occurred).
Election Out for Small Partnerships
Partnerships with 100 or fewer qualifying partners will be able to elect out of the new audit rules for any taxable year, in which case the partnership and partners would be audited under the general rules applicable to individual taxpayers. The annual election out must be made with the partnership's timely filed tax return and must disclose the name and taxpayer identification number of each partner of the partnership. To qualify for the election, each of the partners of such partnership has to be an individual, a C corporation, a foreign entity that would be treated as a C corporation were it domestic, an S corporation (number of the S corporation shareholders are counted to determine numeric qualification of 100 or fewer), or an estate of a deceased partner. The election out does not apply if any partner in the partnership is a trust or another partnership. However, by regulations or other guidance, IRS may prescribe rules allowing the election of the small partnership exception where one or more partners do not meet the above description.
The provision represents a dramatic shift in the way IRS handles partnership audits. The rules simplify the process from IRS’ standpoint, making it more feasible for IRS to assess and collect additional taxes related to the income of widely held partnerships. Consequently, these audits are more likely to occur than they did under the prior regime. The rules are more complex from the standpoint of the partners in partnerships. The partnership’s liability for taxes resulting from IRS audits would have an adverse effect on partners in the year an adjustment was made who were not partners in the year that was reviewed by IRS (or of varying ownership interests). Complicated indemnity provisions may be required for partners in partnerships in order to shift potential tax liability amongst partners. As additional details and guidance from IRS on the new audit rules is issued, partnerships will need to consider whether amendments should be made to partnership agreements to reflect these changes to the partnership audit regime.