Two years ago, Congress enacted the Bipartisan Budget Act of 2015, which made significant changes to the way partnerships are audited. The Act requires that tax be assessed and collected at the partnership level instead of the partner level. The previous audit regime, the 1982 “TEFRA” rules and the 1997 electing large partnership rules, had a complicated process where income items had to be identified as partnership items or partner-level items, leading to controversies over different items of income. The IRS has re-released proposed regulations to implement the new law. The IRS regulations were originally released in January 2017, but were delayed by President Trump’s January 20th, 60-day regulatory freeze. Now the IRS is trying again.
No More Chasing Down Partners
The new system is designed to simplify the large partnership audit process by having all items of income, gain, loss, deduction, or credit be adjusted at the partnership level. Then, the partnership will be liable for any resulting underpayment of tax. Any penalty or addition to tax that results from the audit also would be determined at the partnership level.
This simplification mostly benefits the IRS by facilitating the tax collection process, particularly for large multi-tiered partnerships and multilayered LLCs. These complex partnership structures have made it difficult for the IRS to identify and reach the individual partners and their assets. The proposed rules issued under the authority of the 2015 Budget Act allow the IRS to collect from the partnership without the need to identify the individual partners. Under the prior rules, the IRS must collect from the separate partners based on what those partners owe. Making the partnership pay up streamlines the entire process and makes collection more likely.
Small Partnerships Get Pass
Partnerships with 100 or fewer partners can elect out of the centralized partnership audit process if they have a simple ownership structure. Partners of these small partnerships must include only individuals, C corporations, foreign entities treated as C Corporations, S corporations, or estates of deceased partners. The election is made on the partnership return, and the entity must notify each partner within 30 days. If a partnership elects out, the IRS will pursue deficiencies against the partners who will be audited under the general rules that apply to individual taxpayers.
Once the rules are finalized, they will apply to partnership tax years beginning after December 31, 2017, but partnerships can elect to apply them earlier. A hearing on the proposed rules is scheduled for September 18, 2017.
Consistency, Partnership Representatives
Partners must treat each income item in a manner consistent with the treatment by the partnership. If they do not, the proposed regulations allow the IRS to collect an underpayment of tax from an inconsistency under an expedited procedure. In addition, the new rules swap out the “tax matters partner” for a designated “partnership representative” who has the authority to bind all of the partners. Non-partners can act as partnership representatives. Finally, individual partners will no longer be able to participate in the audit.
How to Prepare
With a 2018 tax year effective date, partners have some time to prepare for the new regulations. It is important that partnership agreements be amended to designate a partnership representative and to add language about whether the partnership wants to elect out of a centralized audit, if eligible. Partnerships also will have to address the situation where some partners may not have held interests in the partnership for the reviewed year but are liable for the tax as partners in the year of adjustment. Finally, those buying into a partnership as new partners should first investigate the entity’s tax records to determine whether they could be liable for the entity’s past tax obligations.
The rules are complex and have some benefits and some new burdens. Consult your Frazier & Deeter tax advisor to help you prepare for the 2018 implementation of the new centralized partnership audit rules.