Partnership Audit Rules Check In: Is Your Partnership or LLC Prepared? (article)

Partnership Audit Rules Check In: Is Your Partnership or LLC Prepared?

With all of the tax changes taking effect in 2018, pass-through entities may have overlooked an important provision from a few years ago: the new partnership audit rules. The IRS’s new rules for auditing partnerships, including LLCs, introduced in the Bipartisan Budget Act of 2015 (BBA), took effect for tax years beginning after Dec. 31, 2017. Although the rules are extremely complex, the biggest impact is that partnerships will now be responsible for paying tax deficiencies unless the partnership elects to use an available option, and the new position of “partnership representative” gives that person much greater power to make binding decisions than the traditional “tax matters partner.”

As originally promulgated, the new partnership audit rules contained numerous provisions that were unclear. The IRS published proposed regulations to help clarify some of the biggest issues, including the opt out rule, nuances involved with the selection of various methods to modify an imputed underpayment, and the allocation of imputed underpayments among partners when their interests in the partnership have changed between the reviewed year and the adjustment year.

In the absence of final guidance on some of the unclear provisions, the American Institute of CPAs (AICPA) had asked Congress to delay the start of the new partnership audit rules by one year. The recommendation was not taken up. In March, President Trump signed a spending bill, the Consolidated Appropriations Act of 2018 (CAA) that finalized some of the ambiguous provisions in the centralized audit regime. By addressing the new rules in the legislation, Congress confirmed that the rules will be effective for the 2018 tax year.

Partnerships need to familiarize themselves with all the legislative and administrative developments regarding the new partnership audit rules to make sure they are prepared. There are some planning options available to push any adjustments back down to the partner level, but the plan to use them should be in place before an IRS exam begins. Additionally, there are proactive steps a partnership can take to minimize potential conflict around decisions to allocate imputed underpayments among the partners.

Partnership Audit Rules Recap

Prior to the BBA, the IRS conducted examinations of partnerships with 10 or fewer eligible partners with separate audits of the partnership and each partner. Examinations of partnerships with more than 10 partners, or partnerships with any ineligible partner (partnerships, trusts, certain foreign entities, estates, and certain other entities) were instead conducted under the TEFRA unified audit procedures.  Under these procedures, audit proceedings were conducted at the partnership level, and any adjustments were binding on all of the partners. Partnerships with 100 or more partners could elect to be electing large partnerships (ELP). Any audit adjustments for ELPs were treated on a unified basis and reflected on the partners' current year return. Under any of these audit scenarios, refunds were paid to partners and deficiencies were collected from partners, meaning the IRS had to deal with each partner individually.

The BBA repealed the TEFRA procedures and the ELP designation. Under the new rules, the IRS conducts audit proceedings at the partnership level for a “reviewed year” (the tax year being audited), and assesses any adjustments (imputed underpayments) in the year the review is completed, “the adjustment year.” By default, imputed underpayments are paid at the partnership level in the adjustment year.  Partnerships with 100 or fewer eligible partners, however, may elect to opt out of the new rules.

CAA Clarifies Push-Out Adjustment

The partners in an adjustment year may differ from the partners in the reviewed year, or partners’ percentage interests in the partnership may change. If a partnership undergoes an IRS exam and the IRS discovers imputed underpayments, the “adjustment year” partners could be left footing the bill attributable to “reviewed year” partners who have departed. The push-out election permits partnerships to take the imputed underpayment and push it out to the reviewed year partners, thereby restoring parity between the partners who benefitted from the initial reporting and those suffering the burden of the tax deficiencies in later years.

Initially, it was unclear as to whether a push-out adjustment would be limited to direct partners. The CAA modified the rules so that partnerships can implement the push-out adjustment election through all tiers of ownership, which means complex ownership structures can benefit from the push-out election in the same manner that direct owners can.

Partnerships making a push-out election must file a tracking report with information about the push-out adjustment that was allocated to all partners, including indirect partners. Indirect partners (those partners that are S corporations or partnerships) may continue the push-out adjustment to their owners, or may elect to pay an entity-level tax instead. The due dates for payment of tax associated with a push-out adjustment is the tax return date (including extensions) of the partner’s return for the adjustment year.

The CAA also permits partners to push out favorable audit adjustments (imputed overpayments) to partners. As originally written in the BBA, only underpayments were eligible for the push-out adjustment, which created the possibility of partners getting “whipsawed”, i.e., having to pay a deficiency while being ineligible for a refund.

Pull-In Procedures Receive an Update

Partnerships not wanting to use the push-out election have another option to have reviewed year partners to bear the burden of adjustments. Using pull-in procedures, some or all of the reviewed year partners calculate and pay their share of taxes and make changes to their tax attributes as a result of the partnership audit adjustments. The pull-in procedures do not require the filing of an amended return and do not result in any corollary effect on the partners’ adjustments to other tax years, beyond the effects on tax attributes. Further guidance is needed on how partners report and pay tax under the pull-in procedure.

CAA Clarifies No Escape from Self-Employment and Net Investment Income Taxes

Some partnerships may choose to follow the default rule and let the partnership pay the imputed underpayment. This may reduce the administrative burden of divvying up the imputed underpayment among their partners. But another clarification in the CAA may make the default rule less appealing, particularly for complex partnership arrangements.

The CAA provides that when a partnership utilizes the default rule to pay the imputed underpayment, the partners are still liable for and must pay separately any self-employment or net investment income taxes that result from the imputed underpayment. These taxes cannot be paid by the partnership because the imputed underpayment consists only of income tax. Partners who might owe these additional taxes as a result of the partnership exam adjustments will need the information from the partnership about their allocable share of the adjustments in order to file their amended returns for the reviewed year.

Clarification of Adjustment Netting

The BBA provided that favorable and unfavorable adjustments could only be netted if they were of the same character (capital or ordinary). The CAA clarified that taxpayers cannot net items of partnership loss that could be subject to the passive loss rules of Section 469, regardless of whether partners actually are subject to such rules.

Other 2018 Partnership Audit Rules Updates

In August, the IRS issued final regulations on the role of the partnership representative. Under the BBA, only the partnership representative interfaces with the IRS during the audit examination. Furthermore, the partnership representative has the sole authority to act on behalf of the partnership and take any action that is binding on the partnership and all of its partners.

The final regulations clarify that a disregarded entity can serve as a partnership representative, and a partnership may designate itself as a partnership representative. The final regulations also provide guidance on the timeline for changing a partnership representative and the procedures for a resigning representative.

What Partnerships Need to Do Now

Partnerships may have put off a complete evaluation of the new partnership audit rules in hopes that Congress would delay the effective date. The CAA and final regulations issued by the IRS provide that the new rules are in effect now and will not be delayed. To prepare for the rule changes, partnerships should review their options for paying imputed underpayments, and every partnership needs to amend its partnership or operating agreement. The push-out and pull-in procedures require partners to agree that they will be paying tax deficiencies at the partner level, and that this is in the best interest of the partnership. Once an IRS exam of a partnership begins, partners will have limited time to evaluate their elections or modification options. And the old “tax matters partner” does not automatically become the new “partnership representative.”  Partners need to appoint a representative and spell out his or her authority for making binding decisions.

For more information about how the new partnership audit rules could affect your partnership, please contact your local CBIZ MHM tax professional.

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Partnership Audit Rules Check In: Is Your Partnership or LLC Prepared? all of the tax changes taking effect in 2018, pass-through entities may have overlooked an important provision from a few years ago: the new partnership audit rules....2018-12-31T16:38:30-05:00

With all of the tax changes taking effect in 2018, pass-through entities may have overlooked an important provision from a few years ago: the new partnership audit rules.

Federal Tax