Kevin J. McPherson, BridgeTower Media Newswires
The IRS recently changed the way partnerships (and LLCs taxed as partnerships) will be audited in the near future. Under the old rules, the IRS would audit the books and records of a partnership and determine if an adjustment to the partnership’s income is warranted. If the answer is “yes,” since a partnership is generally not a taxable entity (partnership income passes through to the individual partner’s tax return), the IRS is forced to pass these adjustments through to each individual partner for the year under audit, who would then remit the additional tax.
Under the new rules, for audits of tax years beginning after 2017, the IRS will now assess and collect tax from the partnership rather than from the individual partners. However, the more significant change is that the partnership will be assessed in the year the audit concludes and not in the year under audit. This shifts the economic burden from “the sinners,” those individuals who were partners during the year under audit, to the current partners. This may not be an issue for the small mom-and-pop partnerships that have few partners, but it is likely to have a significant impact on those larger partnerships that have a steady turnover of partners.
In dealing with the new audit rules, the IRS does provide three options, each resulting in different outcomes to the partnership and its owners. First, the partnership can elect to opt out of the new rules. This election must be made annually on a timely filed tax return. This will result in an audit being conducted in similar fashion to an audit under the old rules, where those partners responsible for the underpayment of tax are flagged for their “misdeeds” and assessed the additional tax.
However, only partnerships that furnish fewer than 101 K-1s and that have as partners only individuals, corporations (including tax-exempt entities), and estates may elect out of these new rules. Partnerships with other partnerships, trusts or disregarded entities as partners cannot elect out. An S-corporation partner does not disqualify a partnership from the opt-out election, but the number of S-corporation shareholders does count towards the 100 K-1s mentioned above.
The second option is for the partnership to make a “push-out” election. Like the opt-out election, this election would push-out the audit adjustments to each individual partner in the year under audit rather than the partnership itself being assessed the additional tax. Similar to the opt-out election, this election results in assessing “the guilty.”
This “push-out” election can be made well after the audit is underway (45 days after the IRS issuance of its final partnership adjustment) and can be made by any partnership. However, this election comes with some administrative and financial costs.
The partnership must furnish a statement to each partner in the year under audit, documenting each partner’s share of the adjustment, and file these statements with the IRS. These statements must be filed no later than 60 days after the final partnership adjustments are issued by the IRS. The individual partners are then responsible for calculating and paying the underpayment for the year under audit and any changes in tax for any subsequent year, as a result of the audit.
If the partnership makes the “push-out” election, the underpayment penalty increases from the federal short-term rate plus three percentage points to plus five percentage points, potentially not an inconsequential amount.
If neither of these elections is made, the new audit rules apply by default. Under these rules, the imputed tax underpayment is computed by multiplying the partnership adjustment by the highest federal personal income tax rate in effect for the year under audit. This underpayment is then paid by the partnership and not by the individuals who were partners during the year under audit. This could result in not only a mismatch of the placement of the economic burden, but also a larger tax assessment — assuming not all partners are in the highest tax bracket.
Regardless of which option is taken, the new audit rules require the designation of a Partnership Representative (PR). If a partnership fails to designate a PR, the IRS has the authority to do so. Similar to the Tax Matters Partner (TMP), a PR is the designated contact between the IRS and the partnership. However, unlike the TMP, a PR’s actions are binding to all partners when it comes to the final results of the audit.
Given these options with their varying economic consequences, it is necessary that each partnership is prepared to deal with the new audit rules. Partnerships may want to consider amending their operating agreements prior to the end of 2017 to address such issues as:
• Designating a PR;
• Outlining the authority of the PR;
• Detailing the process to determine whether or not the partnership will make a push-out or opt out election;
• Ownership restrictions (i.e. not allowing other partnerships to become partners etc.) in the event the partnership would like the option to opt out of the new audit rules; and
• Claw-back provisions to ensure that new partners are reimbursed for the “sins” of former partners.
The new audit rules will make it easier for the IRS to audit partnerships and collect the additional tax dollars due to the federal government. However, partnerships should be proactive in establishing processes to limit the amount of the audit adjustments and to ensure that the economic burden falls on those partners who are responsible for the tax deficiencies. Even though these new rules are not effective until after 2017, now is the time to develop a plan of action to address the significant economic and administrative issues that are likely to arise with the new partnership audit rules.
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Kevin J. McPherson, CPA, is a principal with Mengel, Metzger, Barr & Co. LLP. He may be reached at KMcpherson@mmb-co.com.
