2018 marks a shift in the partnership audit rules. Based on the Bipartisan Budget Act of 2015 (BBA), Congress established a new partnership audit regime, which replaced, among other things, the previous partnership audit rules under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). Under the BBA, the new audit regime took effect on January 1, 2018, leading to an overhaul of many of the previous rules.
Two Rule Changes
According to I.R.C. § 6223, each partnership shall designate a partnership representative:
(a) Designation of partnership representative. Each partnership shall designate (in the manner prescribed by the Secretary) a partner (or other person) with a substantial presence in the United States as the partnership representative who shall have the sole authority to act on behalf of the partnership under this subchapter. In any case in which such a designation is not in effect, the Secretary may select any person as the partnership representative.
(b) Binding effect. A partnership and all partners of such partnership shall be bound–
(1) by actions taken under this subchapter by the partnership, and
(2) by any final decision in a proceeding brought under this subchapter with respect to the partnership.
Under the previous regime, a TEFRA partnership needed to designate a tax-matters partner to liaise with the IRS. Additionally, electing large partnerships were required to designate a partner to represent the partnership. Furthermore, for TEFRA partnerships, partners could participate in the audit proceedings and act in their own self-interest. However, under the BBA regime, only the partnership representative has the statutory authority to liaise with the IRS.
- The Timing of Partnership Adjustments
According to I.R.C. § 6225, partnership audit adjustments occur in the year of assessment:
(a) In general. In the case of any adjustments by the Secretary to any partnership-related items with respect to any reviewed year of a partnership–
(1) if such adjustments result in an imputed underpayment, the partnership shall pay an amount equal to such imputed underpayment in the adjustment year as provided in section 6232, and
(2) if such adjustments do not result in an imputed underpayment, such adjustments shall be taken into account by the partnership in the adjustment year.
Under the previous regime, if partnership adjustments were required and resulted in additional tax, the tax would be assessed against each partner in the year the understatement arose (i.e., the reviewed year). Now, however, under the BBA’s default rule, additional tax (called an “imputed underpayment”) is assessed against the partnership in the year the adjustment occurs (i.e., the adjustment year). This can obviously create issues when partners change, as new partners may be on the hook for tax positions taken by previous partners.
Electing Out
In the event a partnership wishes to elect out of the new rules under the BBA, it may have that option if it qualifies. According to I.R.C. § 6221, partnerships may elect out under certain circumstances:
(b) Election out for certain partnerships with 100 or fewer partners, etc.
(1) In general. This subchapter shall not apply with respect to any partnership for any taxable year if–
(A) the partnership elects the application of this subsection for such taxable year,
(B) for such taxable year the partnership is required to furnish 100 or fewer statements under section 6031(b) with respect to its partners,
(C) each of the partners of such partnership is an individual, a C corporation, any foreign entity that would be treated as a C corporation were it domestic, an S corporation, or an estate of a deceased partner,
(D) the election–
(i) is made with a timely filed return for such taxable year, and
(ii) includes (in the manner prescribed by the Secretary) a disclosure of the name and taxpayer identification number of each partner of such partnership, and
(E) the partnership notifies each such partner of such election in the manner prescribed by the Secretary.
(2) Special rules relating to certain partners.
(A) S corporation partners. In the case of a partner that is an S corporation–
(i) the partnership shall only be treated as meeting the requirements of paragraph (1)(C) with respect to such partner if such partnership includes (in the manner prescribed by the Secretary) a disclosure of the name and taxpayer identification number of each person with respect to whom such S corporation is required to furnish a statement under section 6037(b) for the taxable year of the S corporation ending with or within the partnership taxable year for which the application of this subsection is elected, and
(ii) the statements such S corporation is required to so furnish shall be treated as statements furnished by the partnership for purposes of paragraph (1)(B).
(B) Foreign partners. For purposes of paragraph (1)(D)(ii), the Secretary may provide for alternative identification of any foreign partners.
(C) Other partners. The Secretary may by regulation or other guidance prescribe rules similar to the rules of subparagraph (A) with respect to any partners not described in such subparagraph or paragraph (1)(C).
Based on the foregoing provisions of the Internal Revenue Code, only certain partnerships may be able to elect out of the new rules regime under the BBA. To qualify, the partnership may have no more than 100 partners; the partnership must explicitly elect out of the new regime by making an annual filing with its tax return; and every partner must be either an individual, C corporation, S Corporation, estate of a deceased partner, or a foreign entity (only if it would be treated as a C corporation if it were domestic).
Overall, qualifying partnerships should consider whether opting out of the new partnership audit rules is the right option for them. While there are other considerations, two of the new rule changes mentioned above—the partnership representative and the timing of partnership audit adjustments—should factor into a partnership’s determination. Regardless all federal partnerships should consider amending their partnership or operating agreements to address the BBA’s new regime.
For more on the new partnership audit rules, see our prior posts:
- Why (Nearly) Every Partnership Agreement Should be Amended
- Major Changes are in Store for the Partnership Audit Rules
- The Evolution of Partnerships and Partnership Audits
- The New Partnership Audit Rules: An Expansive Scope and Penalty Defenses
Need assistance in managing the business tax audit process? Freeman Law’s representations include disputes involving a variety of claims, such as breaches of fiduciary duty, business torts and other commercial disputes, partnership disputes, misrepresentation, deceptive trade practices act (“DTPA”) violations, tortious interference, extortion, Texas Theft Statute violations, civil conspiracy, and cyber and computer violations. We offer value-driven services and provide practical solutions to complex tax issues. Schedule a consultation or call (214) 984-300 to discuss our business litigation services.
