New federal partnership audit rules effective for 2018 make fundamental changes to IRS audit powers over partnerships (including LLCs taxed as partnerships) and how any unpaid tax liability assessed as part of that audit can be collected. Please note that an LLC that qualifies as a “disregarded entity” or has elected to be taxed as a corporation is not subject to the partnership audit rules. The purpose of this overview is merely to summarize and highlight some of the important features of the new partnership audit rules. Decisions regarding the new audit rules should be discussed with a tax advisor that is familiar with the partnership agreement, the business or other activities of the partnership and the circumstances of the partners.
Although partnerships file income tax returns, partnerships do not pay income taxes on the income reported on the returns. Instead, the partnership’s taxable income is allocated to its partners and each partner includes its share of the partnership taxable income on the partner’s return. Although the new partnership audit rules do not impact these return filing processes, in an audit, the IRS partnership now can collect assessed tax from the partnership.
That is, under the old IRS partnership audit rules (the “Old Rules”), the partnership appointed a “tax matters partner” with authority to respond to IRS audits. Importantly, however, under the Old Rules the partners had rights to participate in the audit and the IRS then had to audit the partners to collect any tax liability. This made it difficult for the IRS to collect tax liability from partnerships that had hundreds of partners, especially compared to the IRS being able to collect the tax from the partnership. Tax professionals refer to the Old Rules as the TEFRA rules based on the Act of Congress that created them.
For 2018 partnerships tax returns, there is a new partnership audit regime, referred to by tax professionals as the BBA rules, based on the Congressional act that created the new rules, or CPAR, centralized partnership audit rules, which we will call the “New Rules.” What are the important differences between the Old Rules and the New Rules? Here is a list:
Partnerships that have fewer than 100 partners may elect out of the New Rules but only if all of the partners of the electing partnership are “eligible” partners. Eligible partners are limited to individuals, C Corporations and foreign entities taxed as C Corporations, S Corps, and estates of deceased partners. The regulations identify other specific types of partners, the presence of which will disqualify the partnership from electing out of the New Rules including, for example, trusts, disregarded LLCs and partnerships.
The 2018 and future partnership tax returns require the partnership to identify its partnership representative and, if the partnership elects out of the New Rules, its partners and the type of “eligible” person the partner is. The partnership can change its elections from year to year (if it is eligible to make an election to opt out of the New Rules).
We recommend that each partnership amend its governance documents to reflect the New Rules. This can be done with a freestanding amendment or by updating and restating the operating agreement. We further recommend that partners consider amending their partnership agreement even if they intend to elect out of the New Rules. The elections under the New Rules are made annually and a change in status of a partner or a transfer of a partnership interest to a new partner could disqualify the partnership from electing out of the New Rules. We prefer to amend the partnership agreement now to operate under both the Old Rules and the New Rules.
Partners also may amend their partnership agreements to bar transfers of partnership interests to partners whose status could disqualify the partnership from electing out of the New Rules. Parties engaged in the purchase or sale of partnership interests must account for the New Rules as part of their pre-transaction due diligence. The partnership representative has the power to cause the income tax underpayment assessed in the partnership audit to be taxable to the partnership or the partners. The application of the New Rules must be evaluated as part of the tax due diligence in connection with the purchase and sale of partnership interests because of the potential partnership liability for the underpayment.
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