New partnership audit rules will become effective for tax years beginning after December 31, 2017. With this change, partnership agreements will have to be reviewed and revised to account for the new rules. Under current regulations, any audit changes made by the Internal Revenue Service (IRS) to partnership income or deductions are allocated to the partners on their income tax returns. Unless certain elections are made, the default rule will be that the partnership is responsible for the tax liability resulting from an IRS audit. The new rules are complex; the following highlights significant aspects of the new regulation.
Option to Elect Out
Certain partnerships may elect out of the new rules. To do so, a partnership must issue no more than 100 K-1s each year, and all partners must be individuals, C corporations, S corporations, or estates of deceased partners. Therefore, if a partnership has another partnership or limited liability company (LLC) as a partner, it cannot elect out. Furthermore, if a disregarded entity, such as a single-member LLC, is a partner, the elect out option is not available. If a partnership elects out, the pre-TEFRA rules (Tax Equity and Fiscal Responsibility Act of 1982) apply. Under these rules, each partner could be audited separately.
Designate a Partnership Representative
Each covered partnership must designate a “partnership representative,” to take the place of the current tax matters partner. This representative must have a significant U.S. presence, but does not necessarily have to be a partner. The partnership representative has broader authority than the prior tax matters partner, and less obligation to notify the other partners. In this vein, partnership agreements may have to contain notification and consultation rights for other partners.
Responsibility for Imputed Underpayment
The basic scheme of the new rule is that the partnership itself is responsible for “imputed underpayment” resulting from any partnership audit. The tax on the imputed underpayment is assessed at the highest tax rate, unless the partnership can demonstrate that a lower rate should apply (for example, due to the fact that a partner is tax exempt). Essentially, this means that the current partners at the time of the audit (during what is considered the “adjustment year”) are responsible for the tax for the year being audited (the “reviewed year”), even if there were different partners for the reviewed year.
To avoid this from occurring, the partnership can make a “push-out” election, which would impose the liability on the partners for the reviewed year, even if they are not currently partners. There are administrative requirements and deadlines imposed on the partnership to send notifications to the former partners. In addition, a higher interest rate on the underpayment would be imposed.
While regulations have been made clarifying many issues, questions still remain, including how a determination is to be made as to the way the rules apply to tiered partnerships. Berdon LLP will continue to monitor the new audit rules for additional clarifications.
Berdon LLP New York Accountants