U.S. Treasury Issues Final Partnership Audit Regulations
The Bipartisan Budget Act of 2015 made sweeping changes to the rules governing IRS audits of partnerships for taxable years beginning after December 31, 2017. Final regulations implementing the new law were recently issued on December 21, 2018. The regulations adopt, with relatively minor changes and clarifications, portions of earlier proposed regulations issued in August 2018. Taxpayers subject to these new audit procedures will be faced with various decisions affecting the treatment of any IRS audit adjustments, and may be required to gather detailed supporting documentation.
Summary of the New Audit Rules
The new rules generally require the partnership itself to pay any “imputed underpayment” of tax due to audit adjustments, along with any applicable penalties and interest. The imputed underpayment is determined by first grouping and netting adjustments to items of income, gain, loss, and deduction and then multiplying the netted adjustment by the highest Federal income tax rate in effect for the reviewed year (currently the top marginal rate applicable to individual taxpayers). The resulting amount is then adjusted to reflect any changes to credits and creditable expenditures.
A partnership may request modification of the imputed underpayment amount for a variety of reasons, including to reflect amended returns voluntarily filed by affected partners, the tax-exempt status of one or more affected partners, reduced effective rates of tax due to, for example, adjustments being attributable to capital gains, and qualifications of foreign partners for tax treaty benefits. Any such requests are subject to significant procedural and substantiation requirements.
In lieu of paying the imputed underpayment amount, a partnership may elect to “push-out” any adjustments to the affected partners. An electing partnership must provide detailed statements to those partners (not simply amended schedule K-1s), who must compute and pay any addition to tax for the year to which the adjustment relates, as well any changes to subsequent years affected by the adjustments (e.g., because of changes to carryovers). The partners must also pay any applicable penalties and interest at a rate that is 2% greater than the normal underpayment rate.
If adjustments are pushed-out to a partner that is a pass-through entity (a partnership, S-corporation, trust or estate), that entity must either provide push-out statements to its members or pay the imputed underpayment amount, penalties, and interest itself.
The new rules also affect the procedures for filing an administrative adjustment request (AAR), the functional equivalent of amended returns. In general, the treatment of adjustments initiated by the filing of an AAR is similar to the treatment of audit adjustments, and a partnership may choose to either pay any imputed underpayment itself, or push out the adjustments to affected partners. However, in the case of an AAR, the partnership does not have to request permission for valid modifications to the underpayment amount, and interest is imposed at the normal underpayment rate.
Certain partnerships are eligible to “opt-out” of the rules described above, and final regulations relating to the opt-out election were published on January 2, 2018. To be eligible, the partnership must have 100 or fewer partners (measured by the number of K-1 schedules it is required to provide to its members during the year). Where an S-corporation is a partner, each shareholder of the S-corporation is counted as an additional partner for purposes of this limitation.
In addition, each partner in an electing partnership must be either an individual, a C-corporation, a foreign entity that is treated as a C-corporation (or would be so treated if it were a domestic entity), an S-corporation, or an estate of a deceased partner. An S-corporation is an eligible partner, regardless of whether one or more of its shareholders are not eligible partners. Thus, a partnership with a partner that is another partnership, a trust, ineligible foreign entity, disregarded entity, or an estate of other than a deceased partner or a nominee, is not eligible to make the opt-out election.
The effect of an opt-out election is that the partnership is not subject to the rules described above, and decisions regarding the audit are generally made by the partners individually. In many cases, the partners will prefer that result. If so, an eligible partnership may elect out on an annual basis with its timely filed return. For the election to be valid, the partnership must disclose various partner information and must notify each of its partners within 30 days of making the election.
The rights of affected partners to be notified of partnership level examinations and to participate in the audit process are restricted or eliminated under the new rules. An important aspect of the new audit rules is the requirement that every partnership designate a Partnership Representative, who will have the sole authority to deal with the IRS about examinations and whose decisions will be binding on all the partners. If the Partnership Representative is an entity, a Designated Individual must be identified as the person the IRS will be dealing with. Final regulations relating to the appointment and powers of Partnership Representative were issued earlier in August, 2018.
What Does CohnReznick Think?
The election for the 2018 tax year will need to be made with the 2018 tax return. Additionally, the Partnership Representative and Designated Individual, if applicable, should be identified, as these designations will need to be reported on the 2018 tax return. Taxpayers should also consult their tax advisors regarding amendments that should be made to partnership agreements addressing the new audit rules.
Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.
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