Starting Jan. 1, IRS Can Collect Tax Deficiencies Directly from PartnershipsDecember 5, 2017 | Katherine A. Heptig | |
A new audit regime, effective January 1, potentially shifts tax liabilities among partners. Starting in 2018, the IRS will be authorized to collect tax deficiencies directly from a partnership (including LLCs taxed as partnerships). This will result in current partners bearing tax liabilities relating to prior taxable years, even though the partnership may now have different partners.
This new partnership audit regime was included as one of a number of tax compliance provisions introduced by the Bipartisan Budget Act of 2015 (the “BBA”) and replaces the two existing approaches for auditing partnerships, each of which resulted in the application of adjustments at the partner-level for the year in question.
Partnerships should take steps now to amend their governing documents (partnership agreement or limited liability company operating agreement) to address some of the issues that may be raised by this new approach.
New Centralized Partnership Audit Regime; Partnership Representative
As a result of the BBA, the IRS will examine the partnership’s income, losses, gains, deductions and credits for the year under examination (the “reviewed year”) and, to the extent an adjustment to any of these items results in additional tax liabilities, including penalties and interest, such adjustment will be assessed against, and collected from, the partnership.
The IRS will no longer be required to determine each partner’s share of the applicable adjustments or to compute and assess the tax due by each partner of the partnership for the reviewed year. In effect, the economic burden triggered by the assessment will be borne by the partners during the year in which the assessment becomes final following the audit (the “adjustment year”), and not by those who were partners during the reviewed year.
Furthermore, any resulting tax will be computed at the highest marginal rate for individuals or corporations, as applicable, regardless of the nature of the income or gain.
The BBA also requires the designation of a “partnership representative.” The partnership representative will be authorized to act on behalf of the partnership, whose actions (including the settlement of an audit) would be valid and binding on the partnership and each of the adjustment year partners for purposes of tax law regardless of any other provision of state law. Unlike a tax matters partner, the partnership representative need not be a partner of the partnership. If the partnership fails to designate a partnership representative on its annual tax return, the IRS may select a partnership representative on behalf of the partnership.
Limited Elections Out of New Regime
Certain partnerships with 100 or fewer partners (“small partnerships”) will be eligible to affirmatively elect out of the new audit rules on an annual basis. These partnerships will also be able to require that the IRS separately assess tax with respect to each partner under procedures generally applicable to individuals.
In order to qualify as a small partnership, the partnership may not have partners that are partnerships, single-member LLCs (i.e., disregarded entities), trusts, or estates of someone other than a deceased partner. In addition, for a partnership with an S corporation partner, the number of Schedule K-1s that the S corporation is required to furnish to its shareholders is taken into account in determining whether or not the partnership has 100 or fewer partners.
Alternatively, a partnership that does not qualify as a small partnership or fails to timely make the applicable election, may, nonetheless, elect to have its reviewed-year partners take the adjustments into account on their individual returns if it does so within 45 days following the date of the notice of partnership adjustment. If this latter election is made, the reviewed-year partners will be subject to increased interest charges on any resulting tax due.
Act Now to Amend Your Governing Agreements
Partners should act now to avoid potentially being caught off-guard by unexpected consequences of future audits. Despite the reality that many partnerships will qualify and elect to be treated as small partnerships, others won’t because they may have too many partners or ineligible partners like trusts and other partnerships. Furthermore, some currently eligible partnerships should consider making the below changes in the event they fail to make the annual election or they become ineligible to do so following the admission of an ineligible partner in the future.
A number of helpful revisions are recommended, including:
- Providing for the designation and/or removal of the partnership representative;
- Limiting the partnership representative’s ability to settle an audit without some threshold of partner consent;
- To the extent the partnership qualifies as a small partnership, requiring the applicable annual election be made;
- Restricting the transfer of a partner’s interest to eligible small partnership partners only;
- If an annual election is not or cannot made, requiring the reviewed-year partners to amend their respective returns to address required audit adjustments and satisfy any additional tax liability;
- Requiring reviewed-year partners to provide any reasonably requested information necessary to reduce the partnership’s reviewed-year tax liability; and
- Requiring reviewed-year partners to indemnify the partnership and adjustment-year partners for any reviewed-year liabilities.
Contact your attorney for assistance in amending your governing agreements accordingly.