New partnership audit rules are now in effect for partnership years beginning on or after January 1, 2018.
Under these new rules, the IRS audits a partnership's income, gain, loss, deduction, and credit as well as partners’ distributive shares for a particular year of the partnership. Any resulting audit adjustments are made at the partnership level and taken into account by the partnership in the year the audit is completed.
The general rule is that any audit adjustment resulting in an underpayment, including interest and penalties, will be collected at the partnership level at the highest applicable income tax rate at the time of assessment.
Under the new tax regime, the role of the tax matters partner has been replaced by a partnership representative (PR). The PR’s traits include the following:
- Annually designated by the partnership
- Granted broad powers, including sole authority to bind the partnership and all partners with respect to any proceeding under the Centralized Audit Regime (CAR)
- Can be any person or legal entity, including a nonpartner—if an entity is selected to be the PR, the partnership must designate an individual to conduct the PR’s responsibilities
Under the CAR, audit adjustments are determined at the partnership level. This includes adjustments to the following:
- Other distributive share items
Any tax resulting from these adjustments will then be assessed and collected at the partnership level at the highest individual income tax rate. A partnership can request the IRS impose a lower tax rate by timely demonstrating some or all partners would actually pay tax at a lower rate. Possible scenarios that support this claim include the following:
- The income would have been taxed as capital gain income to the partners.
- The partners consist of lower tax rate partners, such as C corporations or tax-exempt entities.
Under the new regime, the partnership generally accounts for adjustments in the year for which the audit is completed, not the year for which the adjustment relates. This could place an undue economic burden of tax on partners for years in which they weren’t a member of the partnership.
Some partnerships may be able to opt out of the new partnership audit rules. For example, if a partnership has fewer than 100 eligible partners—meaning any of those partners isn’t a trust, partnership, or disregarded entity—the partnership may be able opt out of the CAR.
Doing so requires an election be made with the timely filed partnership return with extensions. This is an annual election and must be made each year in which the partnership chooses to opt out.
Push-Out and Pull-In Elections
As an alternative to the general rule of a partnership directly paying the tax, a partnership may timely elect to push out audit adjustments to partners. The audit adjustments are then passed through to the reviewed-year partners on a statement similar to an amended Schedule K-1.
Another potential option for partnerships required to pay an underpayment resulting from a CAR audit is referred to as the pull-in election, which allows the reviewed-year partners to pay the tax due under an amended tax return filing procedure without actually filing amended returns.
Provided the pull-in election is timely elected by a partnership and upon proof of payment by the affected partners of the resulting additional tax liability, this election allows the partnership to reduce its imputed tax by the amount the partners have paid.
Preparing for the New Rules
Most partnerships will find it necessary to amend their partnership agreement to adequately plan for CAR. Partnerships should carefully review their existing operating and governing agreements with legal advisors. Document neglect may lead to disputes in later years, so partnerships will want to be proactive in reviewing agreements to help prevent future controversies.
Why It Matters
If a partnership agreement is silent about how tax costs are allocated to tax-exempt partners upon audit, the PR may overlook a partner’s tax status when assigning liability from an imputed underpayment.
If this occurs, a tax-exempt partner may be allocated a tax liability on income that may have otherwise been tax exempt. Additionally, without appropriate protections in the partnership agreement, a tax-exempt partner could be allocated the tax liability of former partners.
A PR may not be as familiar with the tax status of each partner. This means a PR may offset any imputed underpayment liability by establishing the partnership has tax exempt partners, but, if the PR fails to do so, the tax-exempt partner could end up responsible for tax due—regardless of status.
Tax-exempt organizations will want to be aware of the new audit rules to help ensure their exempt status is preserved with respect to any partnership interests. Being diligent with partnership agreements can help make sure they reflect the appropriate tax-exempt treatment of any audit adjustment associated with a tax-exempt partner. Ensuring the PR’s responsibilities are clearly defined in the partnership agreement can help guarantee it keeps the organization’s exempt status in mind.
We’re Here to Help
For more information about how the proposed regulations may affect your organization, contact your Moss Adams professional.