As part of the Bipartisan Budget Act of 2015, Congress enacted new audit rules that will apply to both partnerships and LLCs. Designed to streamline the current audit process, the rules make it simpler for the IRS to perform audits.
The Old system:
Previously under the Tax
Equity and Fiscal Responsibility Act of 1982 ("TEFRA"), partnership audits occur at the partner’s level. This is based on the theory that the partnership is simply a flow-through vehicle, with relatively limited tax purposes. Hence any real adjustment would have to occur at the partner’s level. The IRS would then collect any underpayments directly from the partners. Thus, under this method, the partner's audit adjustment would depend on the partner's tax rate.
The New Procedures:
Effective for tax years beginning after December 31, 2017, the Bipartisan Budget Act of 2015 mandates that the IRS audits the partnership at the entity level. The IRS then collects any underpayments from the partnership itself in the adjustment year. In other words, the IRS imputes any underpayment for the audited or "review year" to the partnership in the tax year in which the audit adjustments become final.
For example, if in 2019, the IRS audits a partnership and determines that the partnership has underreported income in 2016. It is the 2019 partners who will have to pay the additional tax owe and not the 2016 partners.
Even more bad news, because the IRS audits the partnership and not the partners, audit adjustments will be subjected to the highest taxable rate applicable to individuals or corporation in the audit year. To lighten the load, various factors can decrease the imputed underpayment that the IRS calculates. These factors include the amounts paid on amended returns filed by partners of the reviewed year and underpayments attributable to tax-exempt partners. I.R.C. § 6225(c)(2), (3).
This shift in liabilities is pretty worrisome especially where the partnership composition has changed due to a sale or exchange of partnership interest, death or retirement of a partner, or contributions to the partnership. Back to our example, the new partner would be responsible for any underpayment in taxes, even though he was not responsible for it.
The issue could get even more complicated where the former partner is a Nonresident US citizen and no longer resides in the US.
Others Can Bind You:
Because the partnership, and not the individual partner who is being audited, actions taken by the partnership and any final decision in a proceeding binds both the partnership and all partners. This could cause animosity between a dissenting partner and the partnership (6221).
One approach is to designate a third party as a partnership representative. This allows for impartiality and to ensure actions are taken in the best interest of the partnership. Make sure the representative has the technical skills since the representative can bind the partnership and its partners. Sections § 6223(a).
If a partnership does not have a designated representative, the IRS may select a person to act as the partnership representative. I.R.C. § 6223(a). It is the better option for the partnership to select its representative since the one the IRS picks might not be equipped in handling an audit. More guidance on the rules surrounding a representative will be provided in our part II of the new Partnership Audit Rules
What Can the Partnership Do?
Elect out: Applicable to small partnerships, a partnership can elect out of the new audit regime when it files its return (Form 1065). In order to qualify, the partnership must furnish 100 or less Schedules K-1, to its partners, and all partners are individuals, C corporations, foreign entities that would be treated as C corporations if they were domestic, deceased partners’ estates I.R.C. § 6221(b)(1)(A)-(C), or certain S corporations under I.R.C § 6221(b)(1)(C), (b)(2). The partnership must elect out by timely filing its return for that taxable year and by notifying its partners of the election. I.R.C. § 6221(b)(1)(D), (E).
Under this approach, a partnership may want to amend its partnership agreement to make the election mandatory and to preclude the partnership or partners from taking actions that disqualify the partnership from electing out.
Wait and separate: a partnership can elect out of these new procedures after receiving an adjustment from the IRS. Instead of paying the imputed underpayment, the partnership may elect to provide an adjusted statement (similar to a Schedule K-1) to each partner of a reviewed-year that will then pay the tax attributable to the partnership adjustment. I.R.C. § 6226(a). Of course, this election is only effective to the extent that the reviewed year partners are willing to pay the underpayment.
Indemnification: Partners can amend their current partnership agreements to include tax indemnification provisions for underpayments under the new audit rules. New partnership agreements should include similar provisions. However, until these new indemnification provisions are actually litigated, there are great uncertainties on whether the provisions will work as intended.
Even if the indemnification has been included, this does not guarantee the former partners will honor these provisions. For example, corporate partners may no longer exist or be sufficiently solvent. Individual partners can die or become economically unable to satisfy their liabilities. Domestic partners may renounced their citizenship or expatriate to a foreign country. Remember the audit process can take years.
What can the incoming partner do?
Due diligence: With any purchase, the partner must do thorough due diligence to determine their potential liabilities on audit. The new partner should examine the partnership's audit history along tax treatments for all major transactions and operational items.
Additional indemnification: If a partner purchases its partnership interest from an existing partner, it should demand tax indemnity provisions for the new audit regime in its purchase agreements. These indemnity provisions would be in addition to the allocation and indemnity provisions in the partnership agreement.
Insurance: another possibility is to seek insurance. This would require the seller to put money in escrow for the period of possible audit statute of limitation. It is best to note that this is a fairly recent law.
There could be years of litigation before the previous suggestions are clearly defined. If you believe the partnership audit rules could affect your business, please reach out to us. At Le Tax Law, we’ll be with you every step of the way.
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