Since the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) which created entity-level audit rules, the audit procedures for partnerships remained largely unchanged. These rules helped to centralize partnership audit proceedings by applying adjustments to the treatment of “partnerships items,” including underpayments of tax and penalties at the partnership level instead of requiring the IRS to audit each individual partner.
The TEFRA rules provided the following regarding audits of partnerships:
- Partnerships with fewer than 10 partners: audit is conducted at the partner level
- Partnerships with 10-99 partners: audit is conducted at the partnership level and is binding on all partners
- Partnerships with 100 or more partners and elect to be treated as “Electing Large Partnerships” audited at the partnership level but adjustments generally flow-through to current year partners holding an interest
In November 2015 President Obama signed the Bipartisan Budget Act of 2015 (BBA) which replaced the TEFRA audit rules and created new audit procedures, which the Government Accountability Office had requested in order to aid the IRS in audits of large partnerships. The BBA is effective for all years, beginning after 2017, and creates one set of rules that applies to all partnerships. It does include certain exceptions for partnerships with 100 or fewer partners.
One of the major changes the new BBA rules provide is the ability for partnerships to elect out of the partnership level audit if they have 100 or fewer partners. In order to be eligible each partner in the partnership must be one of the following entities:
- C Corporation
- Foreign entity that would be taxed as a C Corporation
- S Corporation
- Estate of a deceased partner
Be aware that the number of shareholders of an S Corporation partner are counted towards the 100 or fewer partner limit. Additionally, the new procedures provide that audit adjustments to partnerships with more than 100 partners will result in an imputed underpayment at the maximum corporate or individual rate for the reviewed year.
There is an option for these large partnerships to “push-out” the audit adjustment to the partners in the reviewed years within 45 days of the issuance of a Final Partnership Administrative Adjustment. If this option is elected, the partnership will furnish a statement to each partner during the reviewed year and the partner will be responsible for their share of the adjustments.
The BBA also replaced the Tax Matters Partner created by TEFRA with a Partnership Representative. The partnership representative is designated by the partnership, but will be chosen by the IRS if one is not by the partnership. This representative will have the sole authority to act on behalf of the partnership, and the partners are bound by the actions and decisions of their Partnership Representative. This representative can agree to settlements, agree to a notice of final partnership adjustments, make an election to pay the partnership liability at the partner level, and determine other items that can have an impact on all partners.
The broad authority of this partnership representative has created a need for partnerships to review their Operating Agreements to potentially limit the discretion of the partnership representative. This should be done in order to avoid situations where certain partners are adversely affected, while others are not. For example, many partnerships allow for special allocations of income and deductions, and a settlement could affect partners differently based on these allocations. Furthermore, tax-exempt partners may prefer the partnership to elect to “push-out” the adjustment to all partners instead of incur the liability at the partnership level to save on the overall tax liability.
Please consult your tax advisor and attorneys for further details how the new partnership audit rules might affect your business and how you can protect yourself from any adverse effects.