The Bipartisan Budget Act of 2015 established a new “centralized audit” regime for partnerships, including LLCs taxed as partnerships. Although the new audit rules apply to partnership tax returns for tax years beginning after 2017, the IRS didn’t finalize regulations on these rules until December 2018.
A quick refresher
Here’s a brief review of the new audit rules. Most significantly, the rules are designed to shift many of the burdens associated with auditing partnership returns from the IRS to the partnership itself, and its partners. They do this by allowing the IRS to determine tax adjustments — and assess any additional taxes, penalties and interest (at the highest marginal individual or corporate tax rate) — at the partnership level.
The IRS now has the authority to assess and collect taxes from the partnership on these “imputed underpayments” without having to consider partners’ circumstances or tax attributes that might reduce their individual tax liabilities. That burden is now imposed on the partnership, which may 1) seek a modification of an imputed underpayment by demonstrating that it should be taxed at a lower rate or by having partners file amended returns and paying the resulting tax, or 2) electing to “push out” partnership adjustments to the relevant partners.
One risk associated with the new audit regime is that, unless partners from the tax year being audited are held responsible for imputed underpayments, new partners may end up paying tax liabilities that were the responsibility of former partners.
Final regulations narrow scope of new rules
One significant provision of the final regulations narrows the scope of items subject to adjustment under the centralized audit regime. Although proposed regulations would have allowed the IRS to adjust a broad range of items connected to a partnership, the final regulations limit an audit’s scope to items that 1) appear (or are required to appear) on the partnership’s tax return, or 2) are required to be maintained in the partnership’s books and records.
So, for example, an individual partner’s outside basis in a partnership interest wouldn’t fall within the scope of a partnership audit, even if the partnership chooses to maintain that information in its books and records.
The final regulations also set forth complex procedural rules, including rules for requesting modifications of imputed underpayments and making a pushout election.
Steps partnerships should take
There are many steps partnerships can take to minimize the impact of the new audit rules. First, a partnership should determine whether it’s eligible for the “small partnership election.” This allows it to opt out of the centralized audit regime and follow the old audit rules, under which the IRS generally assesses and collects taxes at the individual partner level.
Your partnership is eligible to opt out if it has 100 or fewer partners, all of which are qualifying partners. Qualifying partners are individuals, C corporations (including foreign entities that would be treated as C corporations if they were domestic), S corporations or estates of deceased partners. If your partnership has just one nonqualifying partner (such as a partnership or trust) it can’t opt out, regardless of its size.
It’s also a good idea to amend your partnership agreement to facilitate actions that can reduce the impact of the new audit rules. For example, you might amend the agreement to:
- Require current or former partners to furnish tax information or file amended returns in the event of an audit,
- Require the partnership to make a pushout election in the event of an audit, or
- Indemnify partners against tax liabilities that were the responsibility of former partners.
You should also update the agreement to establish procedures for selecting a partnership representative and set forth the representative’s duties and responsibilities to the partnership. (See “The partnership representative: Choose carefully.”)
Turn to your advisor
All partnerships should familiarize themselves with the final regulations and take steps to protect themselves in the event of an audit, including opting out of the new rules if they’re eligible. Contact your tax advisor for additional information.
Sidebar: The partnership representative: Choose carefully
One significant change under the new audit regime is replacement of the “tax matters partner” with a “partnership representative,” which must be designated each year on the partnership’s tax return. Previously, partners had the right to participate in a partnership audit. But under the new rules and final regulations, the partnership representative has the “sole authority to act on behalf of the partnership” and to bind the partnership and its partners in connection with an IRS audit.
Given this broad authority, it’s important to choose a representative carefully. Unlike the tax matters partner, a partnership representative need not be a partner in the partnership. It can be any individual with a substantial presence in the United States or even an entity (including the partnership itself), provided it designates an individual with a substantial U.S. presence through whom it will act.
It’s also important to ensure that your partnership agreement includes procedures for selecting and removing a representative and a requirement that the representative notify the partners of certain events. And, even though the representative has sole authority to act on the partnership’s behalf from the IRS’s perspective, there’s no reason the partnership agreement can’t place limits on the representative’s authority. For example, it might prohibit the representative from taking certain actions without the approval of a specified percentage of the partners.