Buried in a budget bill in late 2015 lay a repeal of the current rules governing partnership audits and replacing them with a new centralized partnership audit regime that, in general, assesses and collects tax at the partnership level. The IRS was tasked with issuing regulations for the implementation of the rule. In mid-June IRS issued Proposed Regs but there are still unanswered questions and a public hearing will be held later this month to review the comments received.
The new rules will apply to taxable years beginning after December 31, 2017. These rules attempt to streamline the audit procedures for partnerships which generally pushed any audit adjustments out to the partners for partnerships with less than 10 partners (rules with some similarity to these new rules have been available for some time for larger partnerships). This could be an extremely burdensome process – the IRS could require all partners to consent and provide their individual income tax returns for a limited scope review of the pass-through reporting at the individual level and calculate the tax adjustment for each partner separately since each partner has a unique tax situation. Or, they might allow the audit adjustment to be passed out to the partners, by basically issuing amended K-1s, thereby requiring all partners to file amended returns. In effect, the streamlining is to reduce the IRS’ burden.
The new rules allow for a partnership with 100 or fewer qualifying partners to opt out of the new audit rules, in which case the partnership and partners would be audited under the general rules applicable to individual taxpayers (basically same as before), although the audit is still examining items of income, gain, loss, deduction, or credit at the partnership level. The only things that change here are 1) the election must be affirmatively made to opt out, and 2) the definition of qualifying partners. A qualifying partner includes individuals, a deceased partner’s estate, C corps, foreign entities that would be treated as C corps if they were domestic, and S corps. To determine the number of partners in a partnership with an S corp partner, the number of shareholders in the S corp are taken into account. A qualifying partner under this rule does not include another partnership (or multi-member LLC). The Proposed Regs specifically spell out the unqualified partners, which also include disregarded entities and trusts. The reason for excluding these partners is in keeping with the whole point of streamlining the audit process for partnerships.
However, there is some flexibility in calculating the imputed underpayment with general modifications, specific item and other modifications, or election for the alternative payment method, which can essentially bring you back to the same effect as opting out by pushing out the adjustment to the partners. In the case of tiered partnerships, the rules allow the audited partnership to push the liability up only one tier, and the upper-tier partnership receiving the adjustment pays tax as if it were an individual.
The problems boil down to:
- The tax computed at the partnership level will be at the highest rates so the potential for that tax bill being higher than what the aggregate tax increase for all partners would be calculated separately is nearly guaranteed, so selecting the method of satisfying the imputed underpayment is crucial.
- The partners in the current year when a tax is due may not be all the same partners and/or the same % interest as in the year under audit.
- The responsibility for tax collection has been shifted from the IRS to the audited partnership.
- The partnership representative must be selected and then there are issues of indemnification.
We believe these issues will have to be addressed not only in partnership and LLC operating agreements, which will require amendments and/or addendums, but also in partnership interest purchase/sale agreements.
Among the comments that will be addressed via the public hearing, the American Institute of CPAs (AICPA) has submitted a request for a one-year delay in the effective date citing 6 primary reasons:
- Necessary regulations have not been issued by the IRS. They issued these Proposed Regs and shortened the standard comment period from 90 to 60 days. This means less time for comments, and then less than 5 months for IRS to consider the comments, prepare responses, and draft new temporary Regs before the effective date – virtually impossible.
- Withdrawn regulations contained significant gaps. Congress has been trying to fix the partnership audit problem for 20 years. They issued Proposed Regs in 2009 that were not withdrawn until these new Proposed Regs were issued in June and there are considerable gaps between the two that were not addressed in the new Regs.
- Proposed technical corrections would clarify and modify elements of the regime. The Technical Corrections Act of 2016 included items that have not yet been incorporated into the Proposed Regs including the tiered partnership issue.
- Impact on financial reporting standards remains unclear. For those partnerships reporting under GAAP, there are disagreements about financial positions that must be taken.
- Partnerships need to amend or draft their partnership agreements for the new r According to the AICPA, virtually every partnership currently operating in the United States will need to amend its partnership agreements to reflect the new audit regime, including establishing procedures for appointing, replacing and working with the new Partnership Representative, who replaces the Tax Matters Partner. Indemnity provisions, claw-back provisions, notice provisions, mandatory election provisions and other important provisions need to undergo discussion, drafting and approval by every partner. Many of the provisions, says the AICPA, should properly take effect prior to the beginning of any tax year covered by the new audit regime—that is, by January 1, 2018. The AICPA states that there is “near unanimous agreement in the tax practitioner community that this timeframe is simply not feasible.”
- Impact of state tax law remains uncertain. Most states have no provision for collecting an audit assessment directly from a partnership. They will have to resolve how they will be informed of the results of IRS audits and what procedures they will need in order to receive the correct additional tax on their share of any adjustment.
This is only a brief summary of the key changes under the Proposed Regulations. At Cassady Schiller, we can help you navigate the rules and fulfill your obligations. Feel free to contact us to set up a consultation.