Congress recently enacted significant changes to partnerships’ income tax audits. These new protocols dramatically change the Internal Revenue Service (“IRS”) partnership audit process and, quite possibly, both the amount of tax liability paid on audit adjustments and the partners who will bear the economic consequence of that tax liability.
The new default rule requires that audit, adjustment, assessment and collection occur at the entity level, not at the partner or taxpayer level as applied under previous law.
The new rules generally apply to all entities that file partnership income tax returns (IRS Form 1065) for tax years beginning on or after January 1, 2018. For example, a calendar year-end partnership will apply these new audit rules for the first time to its tax year beginning January 1, 2018.
Highlighted New Provisions that May Impact You
Collections Directly From Partnership
The IRS may collect any additional tax, interest and penalties directly from the partnership rather than from the partners. The tax could be collected at the highest individual tax rate of 39.6% instead of the partners’ actual marginal income tax rates.
Tax Liabilities of Prior Partners
Current partners could be responsible for tax liabilities of prior partners. If any percentage change of ownership occurs between the year being audited and the year of assessment-if, for example, the partnership is audited 2 years after the original tax submission-the current partners, indirectly, bear the burden of the tax and related costs of adjustments to prior years’ partnership-related items.
New Elections & Opt-outs
New elections and opt-outs may be available. For example, many partnerships, if eligible, will want to consider and evaluate the annual election to opt-out from the new partnership audit rules.
Partnership operating agreements will almost certainly need revisions to address the application of these new rules, including designation of the “partnership representative” and his or her duties, authority and liabilities, and the allocation of audit adjustments
Potential Action Required and the Need for Planning Today
The new audit rules require partners and multi-member LLC members to carefully review and revise their partnership’s operating agreements.
The new term “partnership representative” replaces the prior “tax matters partner.” The partnership representative responsibility is critical; he or she will act as the single point of contact between the IRS and the partnership and will have full authority to bind the partnership and the partners during an audit.
Before designating a partnership representative, both the partnership and the designee representative will want to ensure that:
- Duties and liabilities of the partnership representative are agreeably set out in the partnership agreement
- All potential conflict of interests are addressed
- There is appropriate flexibility to allow the partnership and the current and former partners to respond to proposed audit partnership adjustments to address (1) who is to directly or indirectly bear the tax and related costs of audit adjustments and (2) how those costs are to be allocated.
Certain partnerships with 100 or fewer eligible partners may affirmatively elect out of the new partnership audit provisions and instead, apply the previous audit rules. To do this, the partnership may make an annual “opt-out” election with their timely filed tax return (Form 1065).
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The above summary only scratches the surface for partners to understand the implications to navigate these new rules. Anticipate squabbles. Detailed analysis for each partnership will be necessary, and most likely, legal counsel will need to be involved.
Please contact your Bennett Thrasher tax advisor if you would like to discuss these new partnership audit changes and review any action required or planning opportunities available.