New IRS Partnership Audit Rules: Are Your Partnerships and LLC’s Ready?

August 2, 2016

  • The 2015 Bipartisan Budget Act (the “BBA”) was signed into law in November 2015.
  • BBA made significant changes to the way IRS will audit partnerships for partnership tax years beginning after December 31, 2017.
  • Members of LLC’s and partners of partnerships should prepare for a potential tax liability resulting from an IRS audit.
  • The BBA repealed the 30-year old TEFRA audit rules and replaced them with new entity-level rules.
  • Under this outline and the Internal Revenue Code, the word “partnership” and “LLC” are synonymous (providing the LLC has more than one Member).

Summary of Old TEFRA Audit Rules.

  • Under TEFRA, a “small partnership” was automatically exempt from an entity-level IRS audit. It didn’t actually exempt the partnership from an IRS audit, but the procedural aspects of a formal TEFRA audit were ignored.
  • A “small partnership” is one having fewer than 10 partners, none of which are LLC’s or corporations.
  • Any additional tax liability (including penalties and interest) resulting from a TEFRA audit passed through to the ultimate individual partners’ personal tax returns. So if IRS audited the 2013 tax return of a partnership in 2016, any additional tax liability would be assessed against the 2013 partners and collected from them.
  • In other words, the partnership itself was not liable.

Summary of New BBA Audit Rules

  • The new IRS audit rules were designed to make IRS’s collection of tax liabilities simpler.
  • As a result, the new rules require a significant redesign of the way partners view their relationship with their partnership, and, with the partnership’s current and former partners.
  • The key features of the new audit rules are as follows:
  • Rather than assessing additional tax against (and pursuing collection from) the partners, IRS will assess the current partnership and collect from it an “imputed underpayment,” which will be subject to the highest individual or corporate tax rate regardless of the actual tax rate applicable to its partners.
    • But, IRS must reduce the highest tax rate for any capital gain items or qualified dividends that would be taxed at a lower rate for an individual partner, or, taxed at a lower rate for a corporate partner.
  • Thus, any additional tax liability from an audit will be assessed against the partnership in the audit year rather than the tax year under audit. As a result, current partners will be liable for the tax errors that benefited the partnership’s prior partners.
    • IRS audits the partnership’s 2018 tax return in August 2020.  Any additional tax liability will be assessed against (and collected from) the 2020 partnership using the highest tax rates applicable to tax year 2018; thus, the 2020 partnership and its 2020 partners suffer economically even though the 2018 partners benefited from those errors.
  • The new law requires a partnership to appoint a “Partnership Representative.” It is not yet known whether IRS will treat this appointee the same as the Tax Matters Partner.

Small Partnership Exception

  • Partnerships with fewer than 100 partners (including partners who are C- corporations, S-corporations, or estate of a deceased partner) may opt out of the new audit rules. Note that opt-out is not permitted if any partner is a trust or another partnership.
  • To opt out, a partnership must:
  • Elect the opt-out each year on its federal partnership return (Form 1065);
  • Inform each current partner of the opt-out election;
  • Submit names and TINs of each partner to IRS, including the names of each of the shareholders of an S-Corp partner.
  • If a partnership opts-out of the new rules, IRS must deal separately with the current partnership (to settle the issues) and then collect the additional tax from partners who were partners during the previous audited year. Thus, if it opts-out, the current partnership and its partners would bear no economic cost from any additional tax liabilities.

Implications for Partnerships

  • As a result, each partnership should update its partnership agreement to remain in compliance with the law, protect its current partners, and ensure that any tax liability is allocated equitably. These changes could include:
  • Requiring managing partners of a small partnership to elect out of the new audit rules annually and comply with the partner notification requirements;
  • Creating rules limiting who can be a partner for those partnerships wishing to remain eligible to opt-out as a small partnership;
  • Establishing rules for electing a Partnership Representative as well as defining actions the partnership representative may take;
  • Allocating any assessed tax liabilities in accordance with agreed upon measures.

Even though these new rules will not take effect until January 1, 2018, the BBA will have a substantive impact on tax planning for all partnerships and LLC’s. As a result, partnerships should take proactive steps to prepare for the new IRS audit rules by reviewing partnership and operating agreements to determine whether amendments are required.

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  • About the Author

    Howard L. Richshafer

    Howard Richshafer's practice is focused on civil and criminal tax problems, estate planning and probate, tax court trial work, mergers and acquisitions, and general corporate business matters.  Howard is also a licensed Ohio CPA.

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