Abstract: A new partnership audit regime gives the IRS the ability to impose tax assessments on partnerships under audit. Here, we discuss the options available to partnerships. Doing nothing or making an uninformed decision could cause the partnership to pay a higher than necessary tax assessment and/or cause the partnership and its partners to waste time and money on unnecessary compliance. As always, we strongly encourage our clients to consult with their trusted tax professionals before making these decisions.
For years ending after December 31, 2017, the Bipartisan Budget Act of 2015 (“BBA”) created a new Centralized Partnership Audit Regime (“CPAR”). These new rules are applicable to all entities treated as a partnership for federal tax purposes and for the first time, makes partnerships liable for U.S. federal income tax assessments.
Why are the new rules important?
Absent a timely election out by qualifying partnerships (discussed below), these rules fundamentally change how tax is assessed and collected upon a partnership audit. For starters, partnerships will be required to designate a partner (or other person) with a substantial presence in the U.S. to be the Partnership Representative (“P-REP”) who will have the sole and binding authority to act on behalf of the partnership with the IRS. The P-REP effectively replaces the Tax Matters Partner of the old TEFRA partnership audit rules that are repealed by the BBA.
The general/default rule will have partnerships paying a tax (“imputed underpayment”) using the highest Section 1 tax rate in effect (currently at 37% for 2018), ignoring (1) the nature of the adjustment(s) (for example, long-term capital gains that would otherwise be subject to a lower tax rate) and (2) the nature of the partners (for instance, a partner that is a tax exempt entity not subject to an income tax). Favorable adjustments that do not offset unfavorable adjustments will be a reduction to income in the adjustment year (usually the year that the audit closes). There are significant and tedious rules surrounding the grouping and netting of unfavorable and favorable adjustments, which are outside the scope of this summary.
There are many obvious inequities associated with the default rules of this new audit regime. For instance, if there has been a change in ownership, new partners could bear the economic burden for tax assessments relating to unfavorable adjustments (and/or benefit from favorable adjustments) relating to years when they were not partners. Fortunately, there are alternatives that can help alleviate some of these inherent inequities; though some of these options (which we will discuss shortly) will come with additional monetary cost and compliance. The P-REP will have many decisions to make, which at times may benefit some partners to the detriment of others.
While the focus of this memo is the effect that the new statute will have on the audit process, the new rules also affect the process for making adjustments to previously-filed partnership tax returns, which is outside the scope of this memo.
Election out for certain partnerships with 100 or fewer partners
Certain partnerships may be able to “elect out” of the new rules if the following eligibility requirements are met:
- Fewer than 100 partners, meaning fewer than 100 K-1’s issued, or that have potential to be issued, e.g., a husband and wife joint K-1 counts as two and each S-corporation shareholder member counts as one.
- Must have eligible partners, meaning all partners must be one of the following: individuals; C corporations (including RICs and REITs); certain foreign entities that would be treated as a C corporation, were they domestic; S corporations; or an estate of a deceased partner.
Partnerships with trusts, partnerships, or LLCs (including disregarded entities/single-member LLCs) are not eligible to elect out.
This election is made yearly on the partnership’s timely filed tax return and is binding to the partnership and all the partners unless the IRS determines that the election was invalid.
If such an election is made, the partnership and the partners will be subject to the pre-TEFRA rules causing audits to be performed at the individual partner level; therefore expanding the potential scope of the audit. It will also be possible to for multiple partners to be audited by different auditors; having the potential for the same partnership item to be audited by several auditors with no requirement that their results conform to one another. Accordingly, partnerships should carefully weigh the pros and cons before making this election.
Other options are available
If the partnership is unable to elect out or chooses not to, the partnership will need to consider the various options available to them throughout the audit process. There are several modifications that a partnership can request to reduce the assessment; the partnership will also have the ability to elect to push out the audit adjustments and not pay the tax. Time constraints exist with each option, so procrastination could be costly.
Modification of imputed underpayments
A partnership that has received a notice of proposed partnership adjustment (“NOPPA”) may request one or more modifications to the proposed imputed underpayment.
The proposed regulations list several types of modifications, which include (but are not limited to):
- Amended returns by reviewed year partners. If one or more partners of the reviewed year return include their respective share of the NOPPA adjustment(s) on an amended return for such year (including any other affected intervening year(s), and pay all taxes due), then the imputed underpayment of the partnership shall be determined without regard to such adjustment(s).
- Tax-exempt partners. If the partnership demonstrates that a portion of the adjustment(s) is allocable to a reviewed year partner that would owe no tax by reason of its status as a tax-exempt entity, then the imputed underpayment will be determined without regard to such adjustment(s).
- Modification based on a rate of tax lower than the highest applicable tax rate. A modification based on a lower rate of tax may be requested with respect to a reviewed year partner that is a C corporation and adjustments with respect to capital gains or qualified dividends that are attributable to reviewed year partners that are individuals.
- Other modifications. Modifications that are not specifically described by the regulations may be requested and allowed if the IRS determines that such modifications are accurate and appropriate.
Alternative to payment of imputed underpayment by partnership (“push-out election”)
The partnership can also make an election (commonly referred to as the “push-out election”) and not pay the imputed underpayment. If elected, the partnership is not required to pay the imputed underpayment but is instead required to furnish statements to the reviewed year partners, who must then take into account their share of the partnership adjustments (both favorable and unfavorable), and calculate and pay their respective tax, penalties and interest (for the reviewed year and any affected intervening year). Refunds will not be issued for any year that the tax is lower as a result of such adjustments.
This election comes at the price of cumbersome compliance at both the partnership and partner level, and will be further complicated when tiered structures are involved. Furthermore, partners will also be subject to an additional 2% interest charge above the normal underpayment rate.
While the IRS is still in the process of issuing and finalizing regulations for this regime, and the state response/impact is still unknown, the federal statute is in place and is not expected to be postponed. Therefore, it is still strongly recommended that partnerships should ready themselves now and start the process of amending their operating agreements to take into consideration such things like:
- Identifying the P-REP
- Limiting the P-REP’s liability and exposure for litigation from disgruntled partners
- Outline required communications between the P-REP and the partners during an audit. Regardless of such terms being included in an operating agreement, the actions of the P-REP will be completely binding on the partnership and its partners
- Cooperation clauses for partners dealing with such items as:
- Departed partners (amending returns, possible reimbursement of imputed underpayments paid by the partnership, etc.)
- If it is the partnership’s intention to elect out of the CPAR, there should be clauses eliminating a partner’s ability to transfer their interests to an ineligible partner (such as a trust or single-member LLC)
For further information, please contact Jodi Bloom-Piccione.