New Partnership Audit Rules

By: Christine Weingart

All business owners with partnerships or limited liability companies taxed as partnerships need to be aware that new partnership audit rules will apply next year. Enacted by Congress in 2015, these new rules generally apply starting with the 2018 partnership tax year, though under limited circumstances partnerships may elect to apply the rules early, and certain small partnerships may elect out of the new regime. The IRS just re-issued proposed regulations to assist taxpayers to implement the new regime.

Overview of New Audit Rules. Under the new streamlined audit approach, the IRS will audit the partnership’s items of income, gain, loss, deduction, credit and partners’ distributive shares for a particular year of the partnership (the “reviewed year”).  Any adjustments will be made at the partnership level and taken into account by the partnership in the year that the audit or any judicial review is completed (the “adjustment year”).

In a significant departure from current rules, the general rule under the new regime is that an “imputed underpayment” will be assessed and collected at the partnership level, and taxed at a flat 39.6% rate (instead of the marginal rate of the individual partners, or potentially no tax if a partner is tax-exempt). By collecting the tax from the partnership in the adjustment year, the economic burden will fall on those partners who own a partnership interest in the adjustment year, regardless of whether they were partners in the reviewed year.

As an alternative to the general rule that an imputed underpayment is assessed and collected at the partnership level, a partnership may elect to “push out” adjustments to its reviewed year partners. The partnership must make this election no later than 45 days after the date of the notice of final partnership adjustment. If the partnership makes this election and sends the required adjustment statements to reviewed year partners and the IRS, the imputed underpayment is paid by the reviewed year partners.

Under the new rules, a partnership can initiate an administrative adjustment request, which it may want to do if it believes that an overpayment has been made. The adjustment would be taken into account in the adjustment year. Such a request would be in lieu of filing an amended partnership return.

Traditional Audit Rules for Partnerships that Elect Out. Partnerships with 100 or fewer eligible partners may elect out of the application of the new rules for a particular year on a timely filed return. Traditional audit, assessment and collection statutes of limitation will apply to the partners of electing partnerships; the tax treatment of an adjustment to a partnership’s items of income, gain, loss, deduction or credit will be determined for each partner in separate administrative and judicial proceedings. If an otherwise eligible partnership has partners that include other partnerships, trusts, or disregarded entities, it will not be eligible to make this election out. Consideration should be given before the end of 2017 to restructure ownership if being able to elect out is important to the partners and the partnership.

Preparing for the New Regime. Many partnerships and limited liability companies will find it necessary or desirable to amend the partnership (or operating) agreement in response to the new audit rules. For example, the familiar tax matters partner is replaced in the new regime by a partnership representative who is not required to be a partner and who has broad powers to take binding actions affecting both the partnership and its partners. Partnerships should carefully choose their representative and assure that their partnership agreements provide guidance for the exercise of the representative’s broad statutory authority. Partnerships also should consider the ramifications of various partnership actions and elections, including the push out election, that affect both the partnership’s own financial condition and the tax attributes passed through to the partners. As well, the new rules provide that partners generally may not participate in or contest the results of an examination or other partnership proceeding without permission of the IRS. Therefore, the partnership should consider what safeguards might be appropriate to protect its own and its partners’ interests in the event of an audit.

The ZKS commercial group is available to review all existing documents and discuss the new rules and their potential impact, as well as to make recommendations regarding changes to same.