The New Centralized Partnership Audit Rules

The Bipartisan Budget Act of 2015 completely revamped the partnership audit rules.

The new rules went into effect January 1, 2018, and the most dramatic change is that IRS will now be able to collect any unpaid tax directly from the partnership rather than from each partner. The new rules first apply to audits of 2018 and later partnership tax returns. The previous audit rules remain in existence for audits of pre-2018 taxable years.

The Unlimited Power of the Partnership Representative

Under the new procedure, partnership audits will be handled by a Partnership Representative (PR). The PR replaces the tax matters partner (TMP) for audits beginning in 2018 and is the sole person representing the partnership before IRS. The partners have no statutory rights to participate in the audit process or even get notice of the audit. Partners desiring to get notice of or be involved in an audit need to have the partnership agreement or other document mandate such involvement.

In addition, while the TMP had to be a partner in the partnership, the PR can be any person provided such person has a substantial presence in the U.S. In order to have a substantial presence in the U.S., the PR must be able to meet an IRS agent in the country at a reasonable time and place, must have a U.S. street address and phone number with an American area code, and must have a U.S. taxpayer identification number.

The final IRS regulations clarified that the PR can be the partnership itself or a disregarded entity (DRE) for tax purposes. If the partnership, a DRE or any business entity is the PR, a designated individual must also be appointed to represent it before IRS. IRS will deal with that individual alone and no one else on all audit matters. The final regulations do allow for the appointment by a power of attorney of an accountant or lawyer who can assist in the audit.

The PR and the designated individual will be included on the annual Form 1065, U.S. Return of Partnership Income. The partnership can change the designation for any subsequent year when the Form 1065 for that year is filed. Once made, the partnership can only alert IRS of a change when the IRS mails a notice of administrative proceeding (NAP) to the partnership, the partnership files for an administrative adjustment request (AAR) or the partnership is notified that IRS will undertake a review of their return.

Options on Collection of Tax Due

After IRS concludes the audit, it issues a final partnership adjustment (FPA) that reports the required adjustments. There are four different methods for how taxes owed as a result of the adjustments will be determined and collected.

The first payment method is a basic default rule that provides that the partnership pays the tax in the adjustment year, which is determined by IRS. This imputed underpayment is often different (and likely higher) from the total tax due if tax liability was determined at the partner level. To alleviate this disparity, the partnership can file a request with IRS within 270 days of the issuance of the FPA to lower the imputed underpayment by showing that a lower tax rate applies to certain partners. The partnership may also request lowering the imputed underpayment by showing that a partner may not owe any tax because of its status as a tax-exempt entity.

The second payment method allows the partnership to make an election to push out the tax liability arising from the FPA to the reviewed year partners. This push-out election must be made by the partnership within 45 days after issuance of the FPA. In this case, the partnership will issue adjusted information returns on Schedule K-1s to those reviewed year partners, which will be issued for the year in which the adjustment is made. That Schedule K-1 is then subject to a simplified amended return process. Although the adjusted Schedule K-1 may be issued in the current year, interest and penalties are due as if the tax were owed from the prior year.

The third payment method modifies the basic default rule if any reviewed year partner chooses within 270 days after issuance of the FPA to file an amended tax return for the reviewed year, which takes into account the partner’s allocable share of the partnership adjustments and that partner pays the additional tax due. If this method is chosen, the imputed tax underpayment owed by the partnership is reduced to take into account that partner’s share of that income.

The fourth option is a new pull-in procedure added by technical corrections included in the Consolidated Appropriations Act of 2018, which avoids filing new returns. Instead, it allows each partner to submit a recalculation of their reviewed year tax liability and pay any added amounts due. The PR can act on behalf of the partners in submitting such recalculation and payments to IRS. In all cases, if the partnership does not agree with the FPA, the PR can contest the FPA in court.

Election Out of New Audit Rules

Partnerships with 100 or fewer partners may elect out of the new rules. If the partnership does opt out, it must provide its partners with written notice within 30-days of making the decision. The ability to elect out is available only if each of the partners is an individual, a C corporation, an S corporation, the estate of a deceased partner, or a foreign entity that would be a C corporation if it was a U.S. corporation. If a partner is itself a partnership, then no election out is available. The election is made on a timely filed Form 1065.

The Takeaway

The new audit rules represent a substantial departure from the previous audit regime. There are many issues to be considered and given the enhanced power of the PR, care must be taken in the choice of a PR and a designated individual.