Start Now to Prepare for New IRS Rules Governing Partnership Audits

The new "partnership-level audit" rules don’t go into effect until 2018, but the regulations issued in 2017 will require operating and partnership agreements to be amended to deal with the rules effective in the upcoming calendar year.

The IRS has established new rules governing audits of partnerships (and entities taxed as partnerships) that address how the audits will be conducted, how adjustments will be taxed and allocated, and which partnerships will be subject to the rules.

THE BASICS

The IRS has structured the new rules around three basic principles. If your partnership is subject to the rules:

  • The audit will be conducted at the partnership level.
  • Only one designated U.S. person will represent the partnership in the audit and will be responsible for all audit decisions. This person is referred to as the "partnership representative."
  • Any tax increase determined by the audit will be assessed and collected at the partnership level.

RULES GOVERNING TAX RATES

The statute states that the tax rate for any partnership-level audit adjustment will be the highest individual or corporate income tax rate in effect for the reviewed year. However, there are also a couple of provisions that could allow for a rate reduction:

  • Any part of the adjustment that could be allocated to a particular partner, including a C corporation or even a tax-exempt partner, could be taxed at that partner’s lower rate.
  • Any part of the adjustment that would be allocated to capital gains or qualified distributions would be taxed at those rates.

THE PROCESS

The new process for audits under the regulations re-issued in the summer of 2017 provide for the following steps:

  • Audit commences with notice of administrative proceeding (NAP)
  • Only the partnership representative participates
  • Audit concludes with notice of proposed partnership adjustment (NOPPA) with imputed adjustment
  • Taxpayer has 270 days from NOPPA to request modifications
  • IRS issues final partnership adjustment (FPA) 270 days after NOPPA
  • Partnership now can within 45 days elect to push out the audit adjustments

OPT-OUT ELECTIONS

Qualifying partnerships will be able to opt out of the new rules, even after they go into effect in 2018. To be eligible for an opt-out election:

  • The partners can only be individuals, C corporations, S corporations or an estate. If a partnership has a non-grantor trust or a partnership as a partner, an opt-out election is not available. The regulations still lists grantor trusts as being ineligible. This will make opting out extremely difficult for many LLCs and partnerships.
  • The partnership must have fewer than a hundred K-1s required to be issued for the tax year. The count includes all K-1s issued by an S corporation partner.

The opt-out election must be made on the partnership return for the elected year, each year the opt-out is elected, and returns must be filed on time.

Eligible Partners Ineligible Partners
Individuals Partnership entities, i.e., upper-tier partnerships
C corporations Trusts
Foreign entities that would be treated as a C corporation if domestic Disregarded entities such as single-member LLCs and grantor trusts
Foreign entities that would be treated as a C corporation if domestic Disregarded entities such as single-member LLCs and grantor trusts
S corporations (each shareholder is counted for purposes of determining the 100 partner limit) Estate of an individual other than a deceased partner
An estate of a deceased partner Nominee partner

While only one person will represent the partnership in an IRS audit under the new rules, the partners will decide through their partnership agreement how broad or narrow to make that individual’s powers.

PUSH-OUT ELECTIONS

Under the new rules, the partnership can simply pay any additional tax resulting from an audit as it is computed – that is, at the reviewed year's highest individual or corporate rate. Or, the partnership can elect to "push out" the tax to applicable partners, presumably the entities responsible for the adjustment.

In the absence of a push-out election, the tax is borne by the current partners. So even a person or other entity that was not a partner in the reviewed year will share responsibility for the tax.

A few nuances of push-out elections that are as yet undetermined or for which there is yet no guidance include:

AMENDED RETURN ELECTION

In lieu of a push-out election, a partnership could chose to have one or more partners file amended returns taking into account their share of the audit adjustments. The amended return election has not generated much interest. As in most cases, the results will mirror a push-out election, except where an audit is adjusting the allocation of deductions between partners, thus creating a tax increase for one partner and a corresponding decrease for another.

PREPARING FOR 2018

While only one person will represent the partnership in an IRS audit under the new rules, the partners through their partnership agreement will decide how broad or narrow to make that individual’s powers. In preparation for implementation of the rules in 2018, partners should address the following questions and issues:

  • Can the partnership representative extend the statute of limitations?
  • Can the partnership representative settle the audit?
  • Can the partnership representative hire outside advisors to assist in the audit?
  • What notice responsibilities, if any, should the partnership representative have to the other partners?
  • Should there be a procedure for removing a partnership representative?
  • Should you permit a transfer to a person who would make an LLC ineligible for an opt-out election?
  • If eligible, should an opt-out election be required?
  • Should a push-out election be required?
  • What other partnership agreement provisions should be considered?
  • Given an opt-out election requires disclosure of S corporation shareholders, the partnership agreement might require an S corporation partner to provide that information.
  • Consideration should be given as to whether partners should be required to disclose personal attributes, such as basis, at-risk and passive loss carryovers, and net operating loss carryovers.

Finally, the new rules encourage filing partnership returns by their due date without extensions, including that doing so reduces the time the IRS has to initiate an audit.

About the Author

Nick is a Principal in the Youngstown, Ohio office of HBK CPAs & Consultants. He is a member of the HBK Tax Advisory Group and has experience with individual, partnerships and corporate tax compliance and research issues.

Nick is also involved in evaluating and assisting with tax software implementation and administration. He is involved in internal staff training and is active in firm sponsored continuing education efforts. Nick provides support to the entire firm regarding federal, state and local tax issues.

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