The Bipartisan Budget Act of 2015 (BBA) included a provision which created new partnership audit rules. It is important to recognize that partnerships (including LLCs taxed as a partnership) will be subject to these new rules for years beginning on or after January 1, 2018. The reason Congress passed the new rules are pretty simple: they decrease the time required for the IRS to complete its work, thus allowing it to audit more entities.
The first change is the creation of the “taxpayer representative.” The taxpayer representative replaces the old tax matters partner. However, the taxpayer representative has a more important role to play. Partners, other than the taxpayer representative, will no longer have the right to participate in a partnership audit or judicial proceeding. Partners will not even be notified by the IRS that the partnership is being audited and will not be able to assist in the partnership’s defense. The taxpayer representative does not have to be a partner in the partnership. The selection of the taxpayer representative is very important not only for the reasons above but the taxpayer representative will be the one to inform the IRS if any of the elections (discussed below) will be used in case of an IRS audit.
Due to the importance of the taxpayer representative, we suggest that partnership (and LLCs taxed as a partnership) agreements should indicate who will serve as the taxpayer representative, how they can be removed, and how a new taxpayer representative will be determined.
Additionally, under the new rules for audits of partnerships, any changes determined in the course of an audit by the IRS of a partnership will be made at the partnership level and the changes will be assessed to the partnership in the year of the audit (or a judicial review) is completed. Furthermore, the amount of the tax will be calculated at the highest marginal rate for individuals or corporations. In practice this could burden current partners with fiduciary responsibility for audits of prior years, even if they were not partners at that time.
All this will happen unless the partnership elects one of these exceptions:
- Small partnerships: The new rules do not apply to electing “small partnerships” which must meet two criteria. First, they must have 100 partners or less. Second, the partners can only be (i) individuals, (ii) estates, (iii) C corporations, (iv) S corporations, and (v) foreign entities that would be C corporations if they were domestic entity. That means if any of the partners are trusts (including a revocable grant trust), a single member LLC, or partnership (i.e. tiered partnerships), the partnership does not qualify for an exception. The partnership must make the small partnership election on a timely filed return and included information regarding all partners on a new form. We recommended that the partnership agreement should indicate whether a qualifying partnership is going to make this election.
- Push-out election: A partnership can elect out of the new audit rules and send amended K-1s to all the former partners. Note that the partnership, not the IRS, must send out amended K-1s. Partnerships wishing to make this election must do so within 45 days of receipt of the notice of a partnership adjustment. To avoid any misunderstandings by the taxpayer representative we believe the partnership agreement should be amended if the elect out election is desired.
- Rate adjustment: As indicated, the IRS will assess any additional tax at the highest corporate or individual rate. The taxpayer representative will have an opportunity to try and demonstrate to the IRS that some or all of the assessment should be at a lower rate.
This article is only an overview of the new partnership audit rules. If you have any question regarding how the new rules might affect you, what you should do if your partnership is audited, and what changes to your partnership agreements may be appropriate, please contact our Tax Department at (781) 407-0300.