For partnerships, including limited liability companies taxed as partnerships, new audit rules are a game changer. The rules apply to returns for partnership tax years that begin after December 31, 2017, including amended returns. The changes aren’t merely procedural; they substantially alter the taxation of partnerships, effectively imposing entity-level taxes on partnerships.
You still have time to prepare for the new rules, but you should begin thinking about how they’ll affect you. If you’re contemplating a new business venture that will be taxed as a partnership, it’s a good idea to address the new rules in your partnership or operating agreement.
Tax on all partnerships
The new audit rules, added by the Bipartisan Budget Act of 2015, will affect all partnerships, regardless of size. However, certain partnerships with 100 or fewer partners will be able to opt out of the new rules (see “Can you opt out?”), but the opt-out process itself involves additional reporting and disclosure requirements.
Under the new rules, the IRS will assess and collect taxes at the partnership level. This is a significant departure from current rules, under which the IRS generally assesses and collects taxes at the individual partner level. By easing the administrative burden associated with collecting tax from individual partners, the new rules will likely produce a dramatic rise in the number of partnership audits.
Can you opt out?
Partnerships with 100 or fewer partners may opt out of the new audit rules by filing an annual “small partnership election.” But before you jump to any conclusions about your partnership’s status, be aware that you can opt out only if your partners are individuals, C corporations (including foreign entities that, were they domestic, would be treated as C corporations), S corporations or estates of deceased partners.
A partnership with just one nonqualifying partner (another partnership or a trust, for example) doesn’t qualify, regardless of its size. This means that tiered partnerships or limited liability companies generally won’t be able to opt out. Also, for any S corporation partners, each shareholder counts as a partner for purposes of the 100-partner threshold.
If you opt out, in addition to filing annual elections, you’ll need to inform your partners of the choice to opt out and provide certain information to the IRS about each partner (including shareholders of S corporation partners).
Tax assessed at highest rate
The new rules don’t just streamline the audit process; in some cases, they’ll actually increase the aggregate tax liability of the partnership and its partners. In an audit under the new rules, the IRS will determine any adjustments to the partnership’s income, gains, losses, deductions or credits — as well as to partners’ distributive shares of these items — and assess any additional taxes, penalties and interest against the partnership.
Additional taxes will be determined by multiplying the net adjustment by the highest marginal individual or corporate tax rate for the audited year. The result is an “imputed underpayment,” which the partnership takes into account in the adjustment year. This approach will create several problems for partnerships and their partners. For example, because the new rules assess the tax at the highest marginal rate, partners lose the benefit of partner-level tax attributes that ordinarily would reduce their tax liability.
To ease this burden, partnerships will be allowed to reduce their imputed underpayment by proving that a portion of it is attributable to tax-exempt partners, partners taxed at lower rates, or income taxed at lower rates (such as capital gains). But compiling this information from all your partners may be time consuming.
Tax mistakes of others
Another significant issue: Because the new rules take additional taxes into account in the adjustment year, current partners may be liable for tax mistakes that benefited former partners. Two exceptions will allow a partnership to shift the liability back to its former partners. Partnerships can reduce or avoid entity-level taxation by:
- Having some or all of the partners from the year under review file amended returns reporting their distributive shares of partnership adjustments and pay the tax within 270 days, or
- Making an election, within 45 days after the audit, to provide partners from the year under review with adjusted information returns. Those partners would then take the adjustments into account on their individual returns for the adjustment year.
These exceptions allow you to avoid inequitable results, but meeting them will be a challenge.
No more “tax matters partner”
By the time the new rules take effect, you’ll need to replace your “tax matters partner” with a “partnership representative.” This person can be a partner or nonpartner and must have a substantial U.S. presence. Choose your representative carefully. He or she will have broad authority to bind the partnership and its partners in dealing with the IRS, and partners will no longer have the right to participate in a partnership audit. Now is the time to begin the process of selecting a partnership representative.
What’s next?
The IRS is working on regulations that will clarify, or even modify, the new rules. In the meantime, familiarize yourself with the new rules and determine whether you’ll be eligible to opt out. If not, consider strategies for mitigating the impact, such as amending agreements to require partners to provide tax information or file amended returns in the event of an audit, or indemnifying partners against unexpected tax liabilities.
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