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The Empire Strikes Tax: Common Traps under the CPAR Rules

A long time ago, in a galaxy far, far away, business entities formed as partnerships or limited liability companies (“LLCs”) never had to worry about paying taxes at the entity level. A corporation, of course, was always subject to taxation.

A C corporation is subject to income tax on its taxable income. An S corporation is sometimes subject to income tax on its unrealized built-in gains or if it generates too much passive income. Partnerships and LLCs are generally exempt from income tax at the entity level.

Prior to the new rules, when a partnership was audited by the Internal Revenue Service (“IRS” or “Empire” [for purposes of Star Wars relativity]), the audit was assessed at the partnership level, but the tax was paid at the individual level by each partner filing an amended return for the year being audited. This older method was known as the Tax Economic and Fiscal Responsibility Act (“TEFRA”). It applied to most partnerships with any regarded or disregarded entities as partners.

In 2017, the Centralized Partnership Audit Regime (“CPAR”) was introduced as part of the Bipartisan Budget Act. The CPAR changed the landscape of partnership audits, as it allows the IRS to both assess and collect any tax owed on an underpayment at the partnership level. The CPAR rules also allow any underpayment to be taxed at 37%. The partners during the year of the audit are responsible for the payment. Any prior partners during the year under audit are not responsible for remitting taxes.

Under TEFRA, the prior partnership audit rules, each entity was required to appoint a tax matters partner (“TMP”). The role of the TMP was as a liaison between the IRS and the entity, if it was ever audited. The TMP was required to inform the entity of any audit issues, provide the owners with notices and sign tax returns. The IRS did not give the TMP any actual powers. It was up to the entity to include language in their partnership agreements addressing the powers of the TMP.

Under CPAR, the TMP designation was discontinued. Now, every entity must have a partnership representative (“PR”). The IRS has granted many powers, statutorily, to the PR. The PR does not have the duty to report back to the other partners. The PR gets to decide whether to follow the below examples should there be similar issues. The PR’s powers can only be restrained by specific boilerplate language that must be used to amend the existing Partnership Agreement.

Scenario 1: Taxation at 37% Under CPAR

Assume that a partnership, Jedi Academy LLC, was formed equally by Luke, Leia, Han and Yoda LLC. The Empire audited the 2018 year in 2020, resulting in an under-reporting of a $1,000 capital gain earned from the sale of a piece of real estate located on the planet Naboo.

Under CPAR, the Empire would send the tax bill directly to Jedi Academy LLC. Additionally, despite the underpayment being attributable to a long-term capital gain, the Empire, under CPAR, could present a tax bill using the highest tax rate listed in the code. So, the tax bill would report a tax due of $370 ($1,000 x 37%), to be paid by the partnership.

Jedi Academy did not like this result at all. Yoda LLC is a single-member limited liability company disregarded for federal income tax purposes. Yoda LLC is 100% owned by Yoda. He is also the wisest member of Jedi Academy LLC and serves as its PR. He read the rules under CPAR and realized that there was an exception to the harsh rule using the highest rate possible, 37%. If, within 270 days of receiving the Proposed Notice of Audit Adjustment, the PR requests modifications to the imputed underpayment, such as revised tax rates, in this case, the tax rates used to calculate the amount owed could be reduced upon Empire approval. Since Luke, Leia, Han and Yoda LLC are treated as individuals for federal income tax purposes, the tax rate used to assess their underpayment should be 20%.

Please contact your Withum Jedi should you have any questions.

So, Yoda sent back the Proposed Notice of Audit Adjustment within the 270-day window and recalculated the tax that Jedi Academy LLC owed for the under-reporting of the $1,000 capital gain to be $200 ($1,000 x 20%). By taking into consideration the above rule, their tax bill was reduced, upon Empire approval, from $370 to $200. Jedi Academy LLC would remit the $200 payment to the Empire once the Final Notice of Audit Adjustment was received. It would be considered a non-deductible expense on the tax return of the year attributable to the payment.

It is important to note that Jedi Academy could “opt-out” of the CPAR rules as long as there are 100 or fewer individual partners. Unfortunately, if one of those partners is itself a partnership, trust or disregarded entity (like Yoda LLC), no opt-out is permissible.

Scenario 2: New Partners Under CPAR

Assume that a lightsaber manufacturer, Sith Sabers LLC (“Sith Sabers”), was formed equally by Palpatine, Dooku, Maul and Vader. In 2020, the Empire audited the 2018 year for an under-reporting of a $1,000 capital gain attributable to the sale of the Death Star that was used in their trade or business.

Under CPAR, the Empire sent the tax bill directly to Sith Sabers. The PR for Sith Sabers, within 270 days of the Proposed Notice of Audit Adjustment, sent back a response detailing the use of the 37% tax rate as being too excessive. The Empire agreed and recalculated the tax using the preferential tax rates, and sent out the Final Audit Adjustment Notice.

So, it comes time for Sith Sabers to pay up, not at 37% but at 20%. Vader, although a partner in 2018 (the year the under-reporting was made), is no longer a partner in 2020. Instead, Snoke joined the entity. Snoke, under the CPAR rules, is obligated to pay the tax on the underpayment, even though he was not a partner during the audited year of 2018. He is actually being forced to pay Vader’s amount.

Palpatine, the most powerful member of Sith Sabers, as well as its PR, reads the rules under CPAR. He discovers that if, within 45 days of receiving the Final Notice of Audit Adjustment, Sith Sabers decides to “push out” the underpayment to the original partners during the audited year. Vader, a partner in 2018, but not in 2020, will be obligated to remit his payment.

Snoke is off the hook. Under this scenario, the partners will pay the tax attributable to the capital gain on a simplified “K-1 like” form and file it with their individual return in the year of the audit. No amended returns are required to be filed.


The new CPAR rules were promulgated to make it much easier for the IRS to collect taxes on an underpayment. In the scenarios above, no longer does the Empire have to search for Luke, Leia, Han or Yoda LLC to pay their taxes on the underpayment. The Empire simply sends the bill to Jedi Academy LLC and collects the tax from the entity. Additionally, the Empire is not forced to differentiate between current and former partners of Sith Sabers.

It’s a new world out there, and whether you are a Jedi, or a Sith, or living in a far, far away galaxy, if you form a partnership, don’t forget the traps set by the new CPAR rules. Please contact Withum should you have any questions or concerns regarding the CPAR rules. We can also assist partnership agreement revisions to be in compliance with the CPAR rules and the PR designation.

Additionally, please be on the lookout for a follow-up article (“Game of Loans – Partnership Audits and the 2020 COVID-19 Tax Act”) regarding the interaction between the CPAR rules and newly passed tax act due to COVID-19.

Author: Jeffrey Clayman, CPA, JD, LLM | jclayman@withum.com

Real Estate Services

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