You may need to amend your partnership or LLC operating agreement for the new IRS Audit Rules.
New IRS partnership audit rules will take effect in 2018 if recently reissued proposed regulations are finalized later this year. While 2018 should not open with a flood of audits in January, virtually all partnership or LLC operating agreements will need to be amended to address how a number of important items under the new audit rules should be handled.
The key takeaways are as follows, and each is discussed in further detail below:
- Under the new IRS rules, any audit assessed amount (the “imputed underpayment”) will be applied and collected at the partnership level. More specifically, any adjustment to a partnership’s income, gains, losses, deductions or credits (and any partner’s distributive share thereof) will be determined at the partnership level.
- Partnerships are responsible for any adjustments in the year the audit is completed. This creates a problem for partners who have left and/or partners who have joined the partnership prior to the close of the audit, unless the partnership agreement addresses (or is amended to address) who is liable for this tax burden.
- “Eligible partnerships” can elect out of these new rules, but must do so each year. Otherwise, the new partnership rules will mandatorily apply. If such an election is made, audit adjustments are made partner-by-partner, with no partner’s adjustment binding on any other partner.
- Alternatively, a “push out” election would offer the ability to elect to have the partnership’s “review year partners” take into account any adjustments made by the IRS, and pay any tax due as a result of those adjustments. Thus, instead of the partnership paying the tax on the imputed underpayment itself, the partnership may push out the tax to the persons who were partners for the reviewed year, so they pay the tax rather than the partners in the current adjustment year. However, there is uncertainty as to how to treat audit push-outs through tiered partnerships, which is an issue the IRS has requested comment on. Currently, the push-out election is not available to upper-tier partnerships that are partners in the entity under audit. The Tax Technical Corrections Act of 2016 (the “TTCA”) proposed rules permitting tiered partnerships to be subject to the push-out election but has not yet been enacted into law. Treasure is deciding whether the principles in the TTCA require enactment or instead can be adopted as part of the final regulations.
- A “partnership representative” must be designated and identified in the partnership’s tax return for each tax year and will have the sole authority to act on behalf of the partnership for purposes of these partnership-level audit rules.
Partnership operating agreements should be reviewed and will need to be amended to address the following non-exhaustive list of issues:
- How the partnership representative will be elected and removed;
- How the partnership representative will give notice to all of the partners of specific events, including whether an election out of the new partnership audit rules will be made;
- Whether the opt-out election or push-out election will be made, and how such decision will be made;
- Transferability of partnership interests that could affect the ability to opt out of the new partnership audit regime (i.e. transfer to non-eligible partners); and
- Imputed underpayments with respect to the “review year” versus the year the audit is closed, and the related tax burden of former partners and/or newly admitted partners.
Application of the New Audit Rules
All adjustments and items relating to a partnership would be determined at the partnership level. Thereafter, any imputed underpayment of tax resulting from the audit is calculated by multiplying the net increase in income by the highest individual or corporate income tax rate in the Internal Revenue Code (currently, 39.6 percent). However, the imputed underpayment amount can be reduced: (1) based on a reduction in the applicable tax rate at the partner level of items of income; (2) based on the allocation of net taxable income to a tax-exempt partner provided such income would not constitute unrelated trade or business income or debt-financed income; (3) or where one of more partners for the review year file amended returns taking into account their increase in federal income tax from the adjustments for the reviewed year and make payment of the tax with the amended returns. Reduction in the imputed underpayment amount may also result with respect to a foreign partner’s reduced income tax rate for certain types of U.S.-source income or as provided under a pertinent income tax convention. Specific procedures are required and should be reviewed.
The partnership itself (subject to certain exceptions) is responsible for any adjustments in the year the audit is completed. This can result in a scenario where if a partner leaves a partnership before an audit takes place and an adjustment is later assessed for a year in which he or she was a partner, that individual will not have to “pay” their share of the assessment. Conversely, if a new partner joins a partnership and a prior partnership year is audited, the new partner would bear the economic impact of the imputed underpayment since it’s paid out of partnership assets.
Electing Out of the New Regime
Certain “eligible” partnerships can elect out of the new partnership audit rules. A partnership would be an eligible partnership if it has 100 or fewer partners during the year and, if at all times during the year, all partners were eligible partners (noted below).
A partnership can only make the election on a timely filed partnership return (including extensions) (Form 1065, U.S. Return of Partnership Income) for the partnership tax year to which the election relates. This is a statement that would contain information about each person that was a partner at any time during the taxable year (name, correct U.S. taxpayer identification number, Federal tax classification, an affirmative statement that the partner is an eligible partner, and any other information required by the IRS in forms, instructions, or other guidance).
If such an election is made, the partnership and partners would be audited under the general rules applicable to individual taxpayers (individual partners would take into account any IRS adjustments and pay any resulting tax due). In order to make the election, the following is required:
- The partnership must affirmatively elect out of the new partnership rules for the tax year;
- For that tax year, the partnership furnishes 100 or fewer statements under Code Section 6031(b) (i.e., Form 1065, Schedule K-1) with respect to its partners;
- Each of the partners of the partnership is an individual, a C corporation, a foreign entity that would be treated as a C corporation were it domestic, an S corporation, or an estate of a deceased partner (“eligible partners”); and
- The partnership notifies each of the partners that such an election is being made.
“Eligible partner” does not include partnerships, trusts, foreign entities that are not eligible foreign entities, disregarded entities, nominees, other similar persons that hold an interest on behalf of another person, and estates that aren’t estates of a deceased partner. (Prop Reg §301.6221(b)-1(b)(3)(ii)). Thus, the opt-out election is not available to a partnership that has a flow-through entity as a partner.
Under proposed regulation section 301.6226-1(a), a partnership will be able to elect to “push out” adjustments to its reviewed year partners rather than paying the imputed underpayment itself. If such an election is made, instead of the partnership the imputed underpayment, the partnership may “push out” the tax and any resulting penalties and interest to the persons who were partners for the reviewed year versus the partners in the adjustment year.
If a partnership makes a valid election, the partnership would no longer be liable be for the imputed underpayment. The election would have to be made within 45 days of the date the adjustment was mailed by IRS, signed by the partnership representative, and properly filed with the IRS. The election would not be valid unless the partnership complies with all applicable requirements. All reviewed year partners would be bound by the election and would be required to take the adjustments on the statement into account and pay any additional tax, penalties and interest as a result. The partnership would issue K-1 forms to the reviewed year’s partners to be taken into account, not in the reviewed year, but in the adjustment year.
There is uncertainty as to how to treat audit push-outs through tiered partnerships. Currently, the push-out election is not available to upper-tier partnerships that are partners in an entity. However, the IRS invited comments on how it might administer the audit regime in tiered structures, including comments on information tracking and information sharing from the partnership to the IRS so that the IRS can monitor whether adjustments properly flow through the tiers and to determine that the proper taxpayers take into account the correct amount of adjustments.
Each partnership will be required to designate a partner or other person (in the manner prescribed by the IRS), as the “partnership representative” for the tax year. There can only be one designated partnership representative for a tax year. If no designation has been made, the IRS may select any person as the partnership representative.
The partnership representative must be a person that has a substantial presence in the U.S., and must have the capacity to act (i.e. cannot be a person legal declared insufficient to handle their own affairs, incarcerated, a liquidated/dissolved entity, etc.).
The partnership representative will have the sole authority to act on behalf of the partnership for purposes of these partnership-level audit rules. For example, the partnership representative would bind the partnership and its partners by his or her actions, including: (1) agreeing to settlements; (2) agreeing to a notice of final partnership adjustment; (3) making an election under Code Sec. 6226; and (4) agreeing to an extension of the period for adjustments under Code Sec. 6233. Further, the partnership representative would need to be the person to raise any defenses to any assessed/imputed underpayment.
For more information around the new IRS partnership audit rules, please complete the form below and a member of our Tax Services team will contact you.
State Specific Tax Audit Issues
The new IRS partnership audit rules are effectuated at the federal level, whereas each individual state has its own tax audit procedures. There are a multitude of issues that may result as to differentiation between the federal and state level with respect to these new IRS partnership audit rules becoming effective.
Will states want partnerships to compute imputed underpayments for resident individuals on the entire federal adjustment and not just the portion sourced to the state? What is the impact of partners changing residency in between a review year and a year in which an audit is closed? Will a federal opt out or push-out election be binding on a state, or will separate state elections be required; will a state allow a different election as compared to the federal level; will different elections be permitted for different states? What is the outcome if a state conducts an audit and makes an adjustment that was not made by the IRS?
This is just a brief glance at issues that may exist. Regardless of whether states adopt the new federal audit rules in their entirety, a similar version, or not at all, there will be increased complexity for state tax authorities and for taxpayers.
If you have any questions or concerns, please contact a member of our tax team by filling out the form below.
Author:CJ Stroh, Esq | [email protected]
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