Ken Degraw, CPA, CFP, CFE – Partner – WithumSmith+Brown, PC
Partnerships get Heartburn
Partnerships have been dealing with an old set of rules under which they were audited by the IRS called the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”). Over the years the IRS and taxpayers realized that the rules were cumbersome and impractical as adjustments were passed along to partners in hopes they would amend their returns. The Bipartisan Budget Act of 2015 changes all of that, effectively eliminating the old rules and setting up an entirely new process that will make the IRS’ job easier to audit more partnerships.
The 2015 Act sets up some significant changes. First, the IRS will now deal with a designated representative at the partnership. Second, subject to a narrow opt-out provision , the IRS will impose the tax deficiency at the partnership level, completely bypassing the partners. The partnership will then have the choice to send revised K-1s to those that were partners during the tax year in question or just pay the tax at the partnership level (effectively pushing the tax cost to the current partners). The new rules will be effective for tax years beginning after December 31, 2017.
The new provisions will require partnerships to, at a minimum, review and amend their offering and operating agreements. Such amendments should be made immediately in most asset management firm scenarios despite the 2018 tax year effective date. This is so because incoming limited partners will want to know if they are potentially buying into pre-existing tax liabilities.
Who is covered?
All partnerships, unless they are permitted to, and elect to, opt-out.
Who can opt-out?
Partnerships with more than 100 partners cannot opt-out. Partnerships that have one or more partners that are, themselves, a partnership cannot opt out. All other partnerships can do so long as all of its partners are individuals, C Corporations, certain foreign entities, or estates of deceased partners. Partnerships with S-Corporation partners may qualify if the shareholders of the S Corporation are identified and, when counted with the other partners, do not exceed the 100-partner limit. Note: partnerships with fewer than 100 partners who have partners that are trusts, other partnerships, or tax-exempts cannot opt-out of the new rules. Thus, in practice, the opt-out provision will be of limited use.
How do I opt-out?
The election is done annually by including the election with its timely, filed income tax return for that year. Included in the election statement are the names of all the partners and tax identification numbers. The partnership must also provide its partners with notice of the election.
What happens if I opt-out?
In the event the partnership is selected for audit, all of the changes will be reflected and passed to the partners for adjustment on their respective amended returns.
What’s a Partnership Representative?
This is a new term for the IRS, and is different from the familiar “tax matters partner.” Essentially the partnership will designate one person, not necessarily a partner, who has a substantial presence in the United States. This person will have the sole authority to act on behalf of the partnership, with their decisions and actions binding the partnership and its partners. Failure to designate a Partnership Representative will enable the IRS to choose one.
How will an audit work under the new rules?
The IRS will select a particular year(s) for the audit and evaluate the items they deem relevant, which is nothing new there. Included in the review are the allocations to the partners. Absent an election otherwise (discussed below), in the event there is a tax adjustment, the taxes, penalties and interest are all assessed to and collected from the partnership itself. The IRS will utilize the highest tax rate for the year in question in assessing the tax. Note that the type of income (capital gains vs. ordinary) and type of partner (e.g., tax exempt) does not impact the tax rate, nor does any potential at-risk or passive limitations that would have applied had a partner reported the adjustment.
The result could produce results that are dramatically different than what would otherwise have been realized. Thus, the rules provide the partnership the ability to prove a lower rate of tax by showing partner specific tax profiles. In practice, this may be hard for a partnership with many partners to do. Treasury has been charged with coming up with the process under which these items will be considered. Note, any tax collected from the partnership itself is a cost economically born by the current partners even though the tax will likely relate to a previous tax year where different partners may have been present.
There is an important exception to the general rule. The partnership can elect to push out the tax adjustments to the partners that existed during the tax year under exam via amended K-1s, effectively shifting the tax adjustment to the partners who will report the change on their respective tax returns. The partners also become liable for any interest and penalty. In order for the election to be effective, the partnership will have to make the election and – within 45 days from the issuance of the notice of final adjustment by the service – issue the adjusted K-1s to its partners. The decision to make the election could hinge on whether the existing partners of the partnership were the same partners who were participating in the year of the adjustment.
Is the Statute of Limitations affected?
The IRS has three years to make an adjustment from the later of:
1. The date the return was filed
2. The due date of the return
3. The date the partnership filed an Administrative Adjustment Request
Should the partnership underreport its income by more than 25%, the time frame moves to six years. Should the partnership not file a return or file a fraudulent return, there is no Statute of Limitations.
There are also some limitations on time periods for the IRS to make adjustments, for the partnership to respond, and for appeal to Tax Court.
What do I need to do now?
There are some things partnerships need to consider while we wait for Treasury to draft regulations under this new statute. Some of these items may require agreements to be amended, including:
1. Will the partnership attempt to elect out of the new provisions, if possible?
2. Will the partnership push adjustments to those who were partners during the period of the adjustment or will the current partner group deal with the assessment?
3. Who will be the Partnership Representative?
4. Will partners be notified of an audit?
There are many unanswered questions with the new audit process that will need to be answered by Treasury regulations. Not the least of which is, what happens where the partnership elects to push the tax adjustments to partners but some or all of the partners are themselves pass-through entities. How does the upper-tier partnership deal with the tax adjustment?
If you have questions regarding the new partnership audit procedures or any other tax issues, please contact your regular Withum partner.