Due to recent tax reform, partnerships have gone through a significant amount of change in the way they are audited and taxed. These new partnership audit rules will result in clients reconsidering their partnership agreements to get ahead of these changes. Prior to acting, one must first understand the new rules, what it means to elect out and how to handle the burden of potential additional tax.
The Bipartisan Act of 2015 went into effect in January 2018 and completely changed how partnership audits will be performed. Under the new rules, the IRS examination will be conducted at the partnership level for all partnership items of income, gain, loss, deduction or credit for an audited taxable year. In general, this means that any adjustments will be applied at the partnership level along with any tax, interest and penalties resulting from such adjustments.
This partnership level tax is referred to as “imputed underpayment” and is calculated by multiplying the net partnership audit adjustments by the highest federal income tax rate for either individuals or corporations. The net imputed underpayment is calculated by considering only net amount of increase tax for the year. Income and expense items of different character may not be netted together, such as capital and ordinary. In addition, the partnership adjustments will be made in the current year, not the year under audit. This could move the tax burden to current partners, even if they were not a partner in the year the tax was incurred. Another big change is that previously tax was not paid at the entity level, but it flowed through to the partners who paid tax on the income directly. The default is the entity pays the tax on any audit adjustments. One item to note is the partnership can elect not to pay the tax and require the reviewed year partners to pay the tax via a push-out election or the pull-in procedure. The procedures will be discussed in more detail later in this article.
Under the new rules, partnerships are required to designate in the operating agreement a “partnership representative” to act on behalf of the partnership and partners. Unlike under the previous rules, this role can be filled by a person outside the partnership. Careful consideration should be given to electing a partnership representative as they will be the sole representative for the partnership with the IRS and the representative’s actions will be binding. A manner of payment should be addressed in the partnership agreement to guide the partnership representative in the case of additional tax from audit adjustments.
There is an election available to opt out of the new IRS audit rules, but specific requirements must be met. For a partnership to be eligible to opt out, it must have 100 or fewer partners and no individual partner can be a partnership, trust or disregarded entity. If the partnership has an S corporation partner, the shareholders of the S corporation will not count toward the 100-partner rule. Additionally, this election must be made annually with a timely filed tax return. Once the election to opt out is made, any litigation, assessment and collection of proceedings will be conducted at the individual partner level, which corresponds to the prior rules.
If the partnership is not eligible to opt out, provisions should be added to the partnership designating a partnership representative and establishing procedures to be followed in case of adjustments. The partnership agreement should address who pays the tax and the method of payment. To avoid entity level tax, the partnership can issue push-out statements to the partners involved in the reviewed years. These partners would then pay the tax on the audit adjustments in the current year. The push-out option has been confirmed to apply to tiered partnership, however, strict deadlines apply:
• The push-out election must be made within 45 days of the Final Partnership Adjustment.
• Push-out statements must be sent to reviewed-year partners within 60 days of adjustments becoming final.
• All push-outs from pass-through partners must be complete by extended due date for tax return of adjustment year.
Pass-through partners in a tiered structure must consider:
• A push-out election to provide statements to reviewed partners.
• Or pay the amount on the statement calculated using imputed interest plus any applicable interest and penalties.
If the deadline for the pushout election has been missed, the partnership has the option of the pull-in procedure. The pull-in procedure is a technical correction (issued in March) that does not require an amended tax return to be filed. Under this method, the reviewed year partners have 270 days from the date the proposed partnership adjustment mail date to do the following:
• Pay the amount of tax due with respect to its share of partnership audit adjustments.
• Agree to reflect the resulting adjustments to such partner’s tax attributes.
• Provide the information used to reduce the partnership’s imputed underpayment in the form and manner specified by the IRS.
The partnership representative or a third party can collect the information and remit to the IRS on behalf of the reviewed-year partners. The pull-in procedure is advantageous because it avoids increased interest rates that apply with the push-out election. However, a partner who takes advantage of this procedure loses the ability to challenge the IRS’ position.
The new IRS partnership audit rules have sparked significant change. Careful consideration should be given regarding designating a representative and addressing how any additional tax will be paid. There are many options available regarding the implementation of the new rules. Planning and restructuring techniques can be applied to reach the desired result. We encourage thoughtful consultation on entity structuring and implementation strategies with a qualified CPA.