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New Partnership Audit Rules Require Planning Strategies

Berdon Tax Team
11.10.2016 | Client Alert
The new rules set forth in the Bipartisan Budget Act of 2015 regarding partnership audits dramatically change how partnership audit adjustments will be administered in the future. Because these new rules apply to returns for partnership tax years beginning after 2017 (unless partnerships elect to apply them early), there is ample time to consider planning strategies.

These proposed rules should be of particular interest to the real estate industry, where investors regularly form partnerships to buy existing or to build/ develop properties.

New Playing Field for Partnerships

Careful planning is necessary because these new rules create a whole new ballgame for partnerships:

  • Pass-through entities can become tax-paying entities with respect to adjustments arising from an audit.
  • The economic impact of the audit adjustment potentially falls on the partners in the adjustment year, not those in the year under review. That means those who pay the price required by the audit may not be the same partners who reaped the benefit in earlier years. New partners will now need to perform tax diligence when investing in existing partnerships.
  • The IRS will collect the assessed amount, plus interest and penalties, from the partnership, not the individual partners.
  • The partnership and all of the partners will be bound by actions taken by a “partnership representative,” who may or may not be a partner but has sole authority to represent the partnership before the IRS. Other partners will have no automatic right to participate in, or receive notice of, IRS action.

While there are options for the partnership to pass the adjustments through to the partners, short timeframes for making this election and higher interest rates limit the desirability of this option.

These new laws replace those that have been in place since the passage of the Tax Equity and Fiscal Responsibility Act (TEFRA) of 1982. Those rules, intended to unify IRS audit rules for entities taxed as partnerships, required that tax treatment of partnership items be consistent for all partners; in other words, each partner’s share of any IRS audit adjustments would impact his or her share directly in the tax year under audit. But shortcomings in that law gave way to the new audit rules adopted late last year.

You Have Options

There are ways to opt out of these new rules: Entities with 100 or fewer qualifying partners may opt out of the new rules on an annual basis. (Note, however, that partnerships owned by other partnerships or trusts will not qualify for the opt-out unless future guidance allows it.) A qualifying partner is currently defined as an individual; a C-corporation; an S corporation; or the estate of a deceased partner. Partners of partnerships that opt out will be subject to the pre-TEFRA audit procedures, so that the IRS may audit each partner separately

Take Action

So what do these new rules mean for partnerships? What actions, if any, should a partnership take in light of these rules?

  • Review your partnership agreement and operating agreements to see if any modifications can or should be made.
  • Watch growth in your existing partnership, with an eye towards not adding non-qualifying partners that will push you past the opt-out range (100 or more partners).
  • Consider modifying your partnership agreement to minimize the potential exposure to the partnership.
  • Designate a “partnership representative” for the audit process and define this individual’s role and responsibilities to the partners.

In coming months, the IRS and Treasury Department will undoubtedly provide further guidance on the implementation of the new rules. For instance, the rules do not address certain scenarios, such as the inability of a partnership to meet its obligation due to bankruptcy or solvency. Nor do we know how state taxing authorities will react to these new federal rules. It is always possible that state taxing authorities will follow the lead of the federal government and change partnership rules on the state level as well.

When considering any of these actions, consult with your attorney and certified public accountant to consider the tax ramifications that these any change in the agreement might produce.

Questions? Contact your Berdon advisor. Berdon LLP, New York Accountants.