The IRS has made it clear that it is focusing on auditing partnerships in the near future. Agency officials have said that partnership audits will increase by 50% in fiscal year 2021. Consequently, it is critical that partners and partnerships are aware of the new centralized partnership audit regime and how it will affect them in the event of an audit. There is no better time for them to consult their accountants and attorneys to determine if changes to the partnership agreement are required.
The New Regime
The Bipartisan Budget Act of 2015 (BBA) repealed the prior audit rules under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) and replaced them with the centralized partnership audit regime (CPAR), effective for tax years beginning after December 31, 2017. For the first time, under Code section 6225, audit adjustments are required to be assessed and paid at the partnership level rather than at the partner level. This means any additional tax (calculated at the highest income tax rate applicable to individuals or corporations), penalties and interest will be required to be paid by the partnership in the year the audit is finalized (“adjustment year”). Any adjustments that do not result in additional tax will also be reported in the adjustment year.
This is administratively easier for the IRS from a collection standpoint. However, it may have negative consequences for the partners. For example, what if the partners in the year the audit is finalized are not the same partners as in the year that is being audited? There are several options available to partnerships that can mitigate the negative effects of a partnership-level assessment, which will be discussed later.
As the regime is relatively new, partnership agreements may not be updated to incorporate some of the issues that arise in an audit under these circumstances. For example, if the partnership pays the tax, how will it be reported on the books? Will it reduce future distributions for the partners? How will allocations and capital accounts be affected? How will this affect the partners who were not partners in the year under audit? Partners should start thinking about addressing these issues in the partnership agreement now to avoid confusion later.
The Importance Of The Partnership Representative
The “Partnership Representative” (PR) under the BBA replaces the “tax matters partner” under TEFRA. The PR is not required to be a partner of the partnership but must have a substantial presence in the US with a US address, telephone number and Taxpayer ID Number. An entity can be a PR if an individual is also appointed. The PR is designated on the partnership tax return every year. If the entity fails to select a PR, the IRS will designate one.
The PR plays a crucial role in the IRS audit process. Very close attention should be paid to who is designated. Under Code section 6223, the PR will have the sole authority to act on behalf of the partnership. The partners will be bound by the decisions and actions of the PR. Except for a partner who is the PR, no partner, or any other person, may participate in the examination process without permission of the IRS. It is important for partnerships to select a PR who has knowledge of the entity, can competently make decisions during the audit, and who will act in the best interest of the partners in dealing with the IRS.
Under the Code, the PR will not be limited by state law, partnership agreements or any other agreement. However, partners should consider consulting their attorneys about including language in the partnership agreement that provides guidelines for the PR. This will have no effect on the IRS audit because the PR will still have sole authority in the audit process. However, as between the PR and the partnership, the partners will have recourse if the PR does not act in accordance with their agreement. Further, unlike under TEFRA, there are no requirements for the PR to communicate the audit status with the partners. It may be beneficial to have a clause in the partnership agreement that requires communication to the partners at various stages of an audit.
Electing Out
Eligible partnerships can elect out of the CPAR on Schedule B-2 of a timely filed tax return (Form 1065). When the entity elects out, IRS proceedings and adjustments will be assessed at the partner level under the general audit rules applicable to individuals instead of at the entity level. An eligible partnership:
1. Has 100 or fewer partners during the year
a. If there is an S corporation as a partner, the number of shareholders in that S corporation counts towards the 100-partner threshold
2. Has only eligible partners which include:
a. Individuals
b. C Corporations
c. Foreign entities classified as corporations
d. S corporations
e. Estates of deceased partners
If the entity has a partnership, trust or disregarded entity as a partner, the partnership will not be eligible to elect out of the regime.
The Push Out Election
As mentioned earlier, a partnership audit adjustment may affect partners in the current year who were not partners in the year under audit. One way to avoid this issue is for the PR to make a “push out” election under Code section 6226 by filing Form 8988, “Election for Alternative to Payment of the Imputed Underpayment.” This election must be made no later than 45 days from the date of the final partnership adjustment from the IRS. This is an important deadline because there is no extension to make the election after the 45-day period.
When this election is made, the taxes, interest and penalties (“imputed underpayment”) are shifted from the partnership to the “reviewed year” partners. The reviewed year is the tax year that was audited and adjusted by the IRS. To make this election, the partnership is required to issue a push out statement to the reviewed year partners. There is specific information that must be included in the statement and it must be signed by the PR and electronically submitted to the IRS.