By: Deborah G. Kosnett, CPA
A major change in how the Internal Revenue Service audits partnerships is quickly approaching. Effective January 1, 2018, all IRS partnership audits will take place at the partnership level, as a result of a centralized partnership audit regime mandated by the Bipartisan Budget Act of 2015. Any tax liability resulting from a partnership audit after this date will be determined and paid at the partnership level; the IRS will no longer calculate separate tax liabilities for each partner. Furthermore, unlike under the current rules, none of the partners will be allowed any say with regard to the audit process. In addition, the partners will have no official right to receive information about an ongoing partnership audit.
The new rules will apply to all partnerships, entities, or other arrangements (including unincorporated joint ventures that share profits and losses; see below) that are treated as partnerships for U.S. income tax purposes. They will also apply to any non-U.S. entities regarded as partnerships for Federal income tax purposes.
Perhaps most important, the new regime mandates that all audit adjustments be calculated at the partnership level, without regard to the types of partners making up the partnership, the assets of each partner, or any other special partner attributes. This is a major change that could have an adverse effect on a partnership’s tax-exempt partners, who could potentially be liable for a portion of an audit adjustment, even if their share of partnership income is excluded from unrelated business income.
Fortunately, there are actions that tax-exempt partners can take to potentially mitigate any negative impact from the new audit regime. The IRS proposed regulations governing the new rules have not yet been finalized, but there are certain aspects of the draft regulations that are unlikely to change. Accordingly, the following steps are recommended:
- Review and amend, if necessary, your organization’s current partnership agreements. Consult with legal counsel regarding any needed amendments in response to the changes, especially the new partnership representative requirements. For example, agreements can be changed to restore partner notice and agreement rights – under the new rules, a partnership agreement can require the partnership representative to provide notice of audit proceedings, call for a partner vote, or otherwise restrict the representative’s activities.Additionally, there likely will be a need to address indemnification issues. As the new audit rules will not look at partner-level agreements, it should be possible to revise a partnership agreement take into account the tax characteristics of different partners (in this case, tax-exempt partners) to adjust what would otherwise be a disproportionate tax burden.
- Check your organization’s other agreements for “accidental partnerships.” Substantial tax penalties will be waiting after 2018 for partners who don’t properly disclose their partnerships. Most partnership agreements are obvious: for example, a typical partnership agreement might be titled “limited liability company,” and the agreement will disclose the entity’s partnership tax status. But there are other types of agreements that may qualify as a partnership for tax purposes. For example, an unincorporated joint marketing and sales contract specifying that all parties will share costs and net profits, likely will fall under the Internal Revenue Code partnership definition. Even if the contract includes a “no partnership” clause, a partnership might still exist. It is a good idea to have legal counsel review any such agreements for possible “accidental” partnership status.Additionally, some experts are counseling that taxpayers should not rely on the “check the box” default entity classification rules. It is always better, they say, to file Form 8832, “Entity Classification Election,” to definitively select an entity’s tax status.
These proposed new audit rules are extremely complex, and this article presents only an extremely limited overview. There are, for example, certain opt-out elections for partnerships with less than 100 partners, though what constitutes a “qualifying partner” for opt-out purposes has not yet been nailed down.
For more information on these new rules, see the June 14th proposed regulations, and “Centralized Partnership Audit Rules are Reissued in Proposed Form.”