New Partnership Audit Rules under the Bipartisan Budget Act of 2015
The new partnership audit rules under the Bipartisan Budget Act of 2015 (the “BBA”) are effective for Partnership Tax Years beginning in 2018. The BBA audit rules apply to partnership adjustments which are any adjustments in the amount of any item of income, gain, loss, deduction, or credit of a partnership or any partner’s distributive share thereof. The Proposed Regulations interpret the BBA broadly and define items of income, gain, loss, deduction, or credit as basically any item or information that is required to be placed on the partnership return.
New Audit Rules + Opt-Out
The new audit rules apply to all partnerships, regardless of size; however, partnerships with 100 or fewer partners can elect out of the new audit rules if the partners are all individuals, C-corporations, S-corporations, foreign entities that would be treated as C-corporations if they were domestic, and estates of deceased partners. Partnerships with LLCs, Trusts, or Partnerships as partners do not qualify.
To opt-out, the partnership must do three things: (1) elect the opt-out on its partnership return every year, (2) the partnership must inform each partner of the election to opt-out within 30 days of making the election, and (3) the partnership must submit the names and taxpayer identification number of each of its partners, including S-corporation shareholders treated as partners for the purposes of the opt-out 100 partner test. The small partnership election is located at the new IRC 6221.
Proposed Regulations regarding the Opt-Out (for partnerships with less than 100 partners or members) indicate that the partner count will be based on the number of K-1s a partnership is required to furnish to partners. If an S-Corp is a partner in a partnership, the shareholders count as partners and the shareholders must be disclosed to the IRS. These items create a possibility that a partnership will be counted as having more than 100 partners when in actuality they have less.
Example: Partnership with 99 members. Two members sell their partnership interest during the year to new parties. The partnership would have 101 K-1s and thus be disqualified from the election.
Example: Partnership with 51 partners consisting of 50 individuals and 1 S-Corp, but SCorp has 50 shareholders, the partnership is deemed to have 101 partners.
Entity Level Taxation:
Instead of assessing individual partners, the IRS will now assess the partnership for imputed underpayment, which will be subject to the highest rate in the review year (generally individual or corporate). The new rule shifts the burden of tax collection from the IRS to separate partners, as the IRS will simply “take” the money directly from the partnership and 2 leave the partners to decide amongst themselves which partners contribute funds to the partnership to make the partnership whole.
The law requires the IRS to assess the partnership in the year of adjustment instead of the year under audit. Because of this provision under the law, it is entirely possible for current partners to be liable for tax errors that did not benefit them, but which did benefit former partners. The law does allow two possible exceptions (IRC 6226 and IRC 6225) to prevent this result which will allow a transfer of partnership-level tax liabilities back to partners in prior tax years. Conversely, if a favorable adjustment occurs, the current partners, not the reviewed year partners, will benefit from overstatements of income in prior years.
Example: IRS audits a 2018 return in 2020. All tax, penalty, and interest is imposed in 2020. All partners in 2020 are liable even if they were not a partner in 2018. Tax, interest, and penalties are not deductible by the partnership.
However, this changes a bit if the partnership ceased to exist prior to the adjustment year.
Example: IRS audits a 2018 return in 2020. The partnership has ceased to exist prior to 2020. The partnership adjustment is against the prior partners.
The new law also requires a partnership to appoint a person or entity with a substantial presence in the U.S. to serve as a partnership representative (“PR”) before the IRS. The PR replaces the tax matters partner under the old TEFRA rules. The PR has the sole authority to act on behalf of the partnership. In the event that the PR is a trust, estate, partnership, association, company, or corporation, a responsible person such as a corporate officer, partner, or trustee must act on behalf of the PR.
If a partnership fails to appoint a PR, the IRS is authorized under the new law to appoint the PR. It is not entirely clear how the IRS will appoint a new PR or how the partnership/LLC will inform the IRS about the PR. The IRS issued a bulletin on July 10, 2017 (Bulletin 2017-28) which merely states that the partnership “shall designate in the manner prescribed by the Secretary a partner or other personnel…as the partnership representative who shall have the sole authority to act on behalf of the partnership. BBA IRC § 6223(a).” Strangely, the Proposed Regulations provide that the partnership may not change the IRS’s designation without the IRS’s permission. Prop. Treas. Reg. § 301.6223-1(e)(4). The Proposed Regulations also prohibit the PR for a tax year from resigning or the partnership from revoking a PR designation before the partnership receives a notice of administrative proceeding from the IRS or files an administrative adjustment request with the IRS with respect to the tax year. Prop. Treas. Reg. § 301.6223- 1(d)(2), (e)(2).
Under these new rules, partners will no longer have the right to participate in a partnership audit or judicial proceeding. Partners will not have the right to receive notice of a partnership audit or be able to raise partner defenses. This will shift the burden of noticing the partners from the IRS to the PR.
Unlike tax matters partners, the PR can be any person including a non-partner. The only limitation is that the PR must have a substantial presence in the United States which would allow the IRS to easily communicate or meet with the PR. The PR is also different than a tax matters partner as the tax matters partner could act for the partnership, but their actions did not bind other partners and their actions could be contradicted by the other partners. Under the BBA, IRC 6223(b) provides that the PR has the sole authority to bind the partnership and that all partners and the partnership are bound by the actions of the PR.
Neither the BBA nor the Proposed Regulations require the PR to communicate with the partnership’s partners regarding developments during an IRS audit and the partners will have no right to participate in the audit. This should be addressed in the partnership/operating agreement. Existing agreements should also be reviewed the address this issue.
The imputed underpayment payable by the partnership is the result of netting all adjustments of income, gain, loss, or deduction for the reviewed year and multiplying the net amount by the “highest rate of tax in effect for the review year” (i.e. the higher of the highest individual or corporate rate). There is no provision for collecting self-employment tax or net investment income tax (the “NIIT”) that might otherwise arise if the adjustments were passed through to the partners. The imputed underpayment rate does not take into account the character of the income so capital gains and qualified dividends are taxed at the highest rate.
Deadlines during Audit
After receiving a notice of proposed partnership adjustment, a partnership has 270 days to provide information or make payments to the IRS to modify the imputed underpayment under the default BBA rule. IRC 6225(c)(7). The IRS may extend this period, but the IRS may not issue a notice of final partnership adjustment until 270 days after the IRS issued a notice of proposed partnership adjustment. The Technical Corrections bill proposes allowing the partnership to waive this limitation. After receiving a notice of final partnership adjustment, the partnership has 45 days to make a push out election. IRC 6226(a)(1).
Push-Out Election or IRC 6226 Election or Alternative Election
The imputed underpayment paid by the partnership at the highest rate is the default rule. A partnership may select an alternative to the default rule and “push out” the imputed underpayment to reviewed-year partners by making an election and providing each reviewedyear partner and the IRS a statement (i.e., an amended K-1) showing the partner’s share of the partnership adjustments as determined in the notice of final partnership adjustment. IRC 6226(a). As previously noted, a partnership must make a push out election within 45 days of 4 receiving a notice of final partnership adjustment. Once made, the election is irrevocable unless the partnership is able to obtain the IRS’s consent to revoke the election. The BBA does not permit or provide reviewed-year partners with the right of review (administrative or judicial) of the imputed underpayment that a partnership pushes out to reviewed-year partners.
IRC 6225 Option
There is an additional option to reduce the imputed tax underpayment that the IRS will be able to collect at the partnership level (i.e., the default rule). IRC 6225(c) requires that the IRS take into account the actual tax liability of the partners when computing the imputed tax underpayment where: (1) at least one partner from the audit year files an amended return consistent with the final partnership adjustment and pays the tax in full, (2) at least one partner from the audited year is tax exempt, or (3) a lower rate should apply because a partner is a CCorp or because the adjustment is made to a qualified dividend or capital gain.
While the exceptions are limited and the IRC 6225 option does not remove the partnership from the new audit rules, it does offer some relief to a partnership from being taxed at the highest individual rate if the partnership is unable to make the small partnership election or the push out election.