The IRS will begin a new way of auditing partnerships and LLCs treated as partnerships for tax years beginning after December 31, 2017. Preemptive actions to protect the interests of real estate businesses and owners must be considered, and partnership agreements may need to be amended.
Partnerships are pervasive in the real estate sector. Multiple development projects by the same enterprise are commonly housed in standalone partnership structures to compartmentalize liability risks for each project, as well as to facilitate varying availability of capital and financing. Flexibility provided by partnerships to accommodate imaginative profit-sharing strategies with a single layer of tax also makes them popular. The number of partnerships and flexibility they permit in creating complex ownership structures (across all industries) has changed the historical perspective on the IRS audit selection process.
History of Audit Process
Since 1982, the IRS has audited partnerships in one of three ways. Examinations of partnerships with 10 or fewer eligible partners were usually conducted by separate audits of the partnership and each partner. Examinations of partnerships with more than 10 partners and partnerships with any ineligible partner were conducted under the TEFRA unified audit procedures (TEFRA), where adjustments are unified and binding on the partners. Lastly, partnerships with 100 or more partners could elect to be electing large partnerships (ELP) for which any audit adjustments were treated on a unified basis and reflected on the partners' current year return. In any of these three ways to audit a partnership, refunds or payments that result from any examination adjustments generally were paid to or collected from the affected partners (with certain exceptions for ELPs).
The Bipartisan Budget Act of 2015 repealed TEFRA and the special rules relating to ELPs. It created new audit procedures that apply to all partnerships that assess and collect underpaid taxes, penalties and interest at the partnership level. Partnerships have several alternative strategies that can mitigate or eliminate a payment liability at the partnership level, shifting the impact of examination adjustments to the partners. Further, partnerships with 100 or fewer qualifying partners may opt out of the new rules by making an annual election to require audits of the individual partners.
Need for Preemptive Action
The availability of these alternatives and the practical ability to take advantage of them are two different matters. Existing partnership agreements do not provide a framework to implement the new rules, nor do they provide for options to mitigate the costs of tax deficiencies. Once an exam begins, partners will have limited time to deliberate over elections and modification procedures. Many preferred audit strategies may require cooperation from the partners and funding tax deficiencies may require specific agreements among the partners.
Real estate partnerships often focus on a horizon to realize development or investment holding potential. An IRS audit that occurs subsequent to this horizon will take place with no partners remaining, and default rules could pass the buck for all examination changes to the last-man-standing partner group. Changing this result may prove challenging, particularly when there are predecessor partners to the last-man-standing group.
For all of these reasons and more, every partnership will likely need to amend its partnership agreement to provide for the necessary framework and strategy to implement the new rules.
Summary of Key Changes
Under the new law, partnerships designate a partnership representative. The partnership's representative will have the sole authority to act on behalf of the partnership and will be the only person who receives notice of key audit stages from the IRS. Actions taken by the partnership representative are binding for partnerships and their partners, and by any final decision in a proceeding brought under the new rules with respect to the partnership.
Assessment and collection of any taxes, interest and penalties relating to an exam adjustment (imputed underpayment) will be applied at the partnership level by default. The imputed underpayment is generally determined by netting adjustments of a similar character and multiplying the netted positive amounts by the highest rate of tax in effect for the year being audited. Although the adjustments are netted with respect to character, the highest tax rate (currently 39.6 percent) applies to any positive adjustment regardless of its character as capital or ordinary in nature. Netted non-positive amounts (favorable adjustments) do not result in refunds and cannot offset netted positive amounts; instead, they are taken into account as income adjustments on the partnership’s tax return for the year during which the exam concludes.
The partnership’s liability for the imputed underpayment can be modified in several ways. Partnerships can request that the IRS use a lower rate to compute the imputed underpayment to the extent the partnership demonstrates to the IRS that adjustments are allocable to partners subject to a lower maximum tax rate than is applied by default. The partnership also can request that the IRS reduce the partnership’s liability for the imputed underpayment to the extent the partnership demonstrates affected partners capture adjustments on amended return filings or incorporate adjustments “pushed out” to such partners.
A partnership can elect to opt out of the new rules for a tax year if during that tax year it issues 100 or fewer Schedule K-1s, has only eligible partners at all times and meets the procedural requirements for making the election. An opt-out election subjects the partnership and the partners to separate audits of the partnership and each individual partner. Eligible partners for purposes of the opt-out election are any partners who are not themselves partnerships, trusts, disregarded entities, nominees and estates that do not belong to former partners. For partnerships with S corporation owners, the number of Schedule K-1s issued by the S corporation partner to its shareholders, in addition to the S corporation’s K-1, count toward the "100 or fewer Schedule K-1s" requirement.
The imputed underpayment paid by the partnership puts the economic burden of a prior year tax adjustment on the current partners of the partnership, regardless of whether the current partners are the same as the partners in the reviewed year. Certain modification strategies can be used, but they may disadvantage reviewed year partners in favor of the current partners or vice versa. Considering the level of authority that the partnership representative has to unilaterally make these choices with the IRS, the partnership agreement should specifically address these issues. Provisions in a revised partnership agreement can be used to document agreement among the partners for the pre-arranged plan to balance their competing interests and ensure the partnership representative will take the actions desired by the partners.
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