The Bipartisan Budget Act of 2015 (BBA) replaced the existing rules for auditing large partnerships with a new set of streamlined rules that take effect January 1, 2018. The new audit rules also apply to any entity that elects to be treated as a partnership for income tax purposes (i.e., LLC). Small partnerships (100 or fewer partners) that do not have a partnership as a partner can elect out of the new BBA rules [Internal Revenue Code (IRC) section 6221(b)]. Presumably, if a small partnership elects out of the BBA rules, then the partnership returns would be audited as part of each partner’s individual audit, as has been true for small partnerships in the past.
These changes are designed to streamline the audit of partnership returns. In general, the audit will take place at, and any adjustment will be taken into account only at, the partnership level; any taxes will be paid by the partnership—not the partners. The new partnership audit rules are examined in detail below.
Each partnership must designate a partner (or other person) as the partnership representative, who has the sole authority to act on behalf of the partnership for the audit. The partner must have a substantial presence in the United States [IRC section 6223(a)]. All partners, as well as the partnership, are bound by the actions taken by the designated partner at any time during the audit, as well as any final decision during any audit-related proceedings [IRC section 6223(b)]. If the partnership does not designate a representative, the IRS is allowed to select “any person” with a substantial presence in the United States as representative [IRC section 6223(a)].
Partnership Adjustment and Tax Assessment and Collection
As under current law, if selected for audit, any adjustment for a partnership tax year is determined at the partnership level. The IRS examines all income, gains, losses, deductions, and credits, as well as the partners’ distributive shares for any taxable year; the net effect of any proposed changes to the items is the adjustment for the partnership. Rather than follow the effect of this adjustment through to the individual partners, any tax effect is also at the partnership level. The adjustment is used to compute an imputed underpayment to be paid by the partnership [IRC section 6225(a)(1)], and the payment is determined using the highest individual or corporate rate of tax [IRC section 6225(b)(1)(A)]. Any penalties are determined at the partnership level [IRC section 6221(a)]; any tax assessed and subsequent collection is at the partnership level. If the adjustment does not result in an underpayment of tax, the partnership will take it into account in the adjustment year as a reduction in non–separately stated income or an increase in non–separately stated loss (as applicable), or tax credits as a separately stated item [IRC section 6225(a)(2)].
In certain cases, a partnership may demonstrate that an adjustment to the imputed payment is appropriate. The IRS has yet to outline procedures to address the following:
- An adjustment must be reallocated to the partners because one or more partners file an amended return [IRC section 6225(c)(2)].
- Part of the imputed underpayment is allocated to a tax-exempt partner [IRC section 6225(c)(3)].
- Part of the imputed underpayment is ordinary income allocated to a C corporation partner or a capital gain/qualified dividend allocated to an individual taxpayer [IRC section 6225(c)(4)].
In general, the audit will take place at, and any adjustment will be taken into account only at, the partnership level.
Unless the IRS consents to a longer period, any materials relating to the determination of a modified imputed underpayment must be submitted within 270 days after the proposed underpayment notice is mailed. Additional guidance is required from the IRS for procedures regarding these submissions [IRC section 6225(c)(5)].
Election to File Amended K-1s
A partnership may elect to provide amended Schedule K-1s to its partners instead of being subject to payment by the partnership. The K-1s will apply to the year under review and any subsequent years that are affected by the adjustment. The election must be made within 45 days of the date of the notice of the final partnership adjustment [IRC section 6226(a)(1)]. With this election, each partner takes into account their share of the adjustment.
Penalties, interest, and additions to tax are paid by each partner in the year of the final partnership administrative adjustment (FPAA). Interest is determined at the partner level, running from the return date of the tax year to which the increase is attributable. The interest rate is computed from the due date of the return year creating the adjustments and computed at two percentage points higher than the normal rate—the federal short-term rate plus three percentage points [IRC section 6226(c)(2)].
The partners’ returns have a “consistency requirement,” under which each partner must treat each adjustment item consistent with its treatment on the partnership return. Any underpayment of tax by a partner because of inconsistent treatment is treated as a mathematical or clerical error subject to summary assessment [IRC section 6222(b)]. If a partner files an inconsistency statement with the IRS, the consistency requirement does not apply [IRC section 6222(c)(1)(B)]. Form 8082 is used to report an incorrectly issued Schedule K-1, which is the most likely reason for inconsistent treatment. These consistency rules are similar to current Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) rules.
New Rules Applied Based on Size of Partnership
Partnerships with more than 100 partners and partnerships having a partnership as a partner are always subject to the new rules. As stated above, however, partnerships with 100 or fewer partners may elect to be audited under individual audit rules. This election is available if—
- the partnership elects out for the tax year [IRC section 6221(b)(1)(A)];
- the partnership provides 100 or fewer K-1s to its partners [IRC section 6221(b)(1)(B)];
- each partner is an individual, C corporation, foreign entity that would be a C corporation under U.S. law, S corporation, or the estate of a deceased partner [IRC section 6221(b)(1)(C)]; and
- the election is made with the partnership’s timely filed return with proper disclosure and the partners are notified of the election [IRC section 6221(b)(1)(D)].
The new law takes effect for partnership years beginning after December 31, 2017. Partnerships may elect early application for partnership years beginning after November 2, 2015 [BBA section 1101(g)(4)].
Period of Limitations on Making Adjustments
The adjustments discussed above must be made by the later of—
- three years after the latest of the day the partnership return was filed, the due date, or the date on which the partnership filed an administrative adjustment request under IRC section 6227;
- 270 days after everything required is submitted under IRC section 6225(c) for a request to modify the underpayment; or
- 270 days after the date of a proposed partnership notice [IRC section 6235(a)].
This date can be extended by agreement, because of fraud, or because of a substantial omission of income. These rules are similar to the general statutes of limitation [IRC sections 6235(b)-(c)].
Effect of the New Rules
Because the partnership must designate a representative (or have one designated for it by the IRS), the new rules will probably reduce the time required by the IRS to locate such person and begin the audit process. In addition, for large partnerships the IRS will no longer have to match and track thousands of different partners. The administrative burden of assessing and collecting taxes at the partner level is shifted from the IRS to the partnership, which can either pay the taxes directly or amend all of the Schedule K-1s for the reviewed year. This aspect of the BBA rules also seems to defeat the original purpose of Subchapter K (pass-through entity).
The new rules are not designed to increase fairness — they are meant to assist the IRS in auditing large partnerships.
Under the new partnership audit rules, partnership audit adjustments are made in the current year, not the year/s under audit, unless the partnership elects to file amended Schedule K-1s [IRC section 6225(d)(2)]. New partners in existing partnerships should therefore be forewarned about bearing the tax burden for adjustments to prior year’s tax returns.
All partnerships and entities treated as a partnership should review and, if necessary, modify their partnership agreement to reflect their elections as to the K-1 adjustment and the partners’ wishes as to the allocation of tax adjustments. New partners should be made aware of these provisions in the partnership agreement.
The new audit rules are very different from the existing rules. For the first time, partnerships are required to pay taxes and penalties rather than passing them along to the partners. The new rules are not designed to increase fairness or reduce the burden on existing partners—they are meant to assist the IRS in auditing large partnerships. Since the IRS only has to deal with the designated partnership representative, perhaps partnership agreements should require that the representative provide information to the partners in a specific manner so that the partners are aware of the IRS’s proposed adjustment.
Proposed regulations on the new rules were issued in January 2017, but were withdrawn as part of President Trump’s regulatory freeze; new proposed regulations were issued in June 2017.
The IRS’s new rules have substantially changed the audit process for partnerships; the Exhibit summarizes the major differences between the old and new laws. Partnerships can expect more audits in the future, but they have some time to prepare, as the rules do not take effect until after 2017. Enterprising tax advisors should take the opportunity to provide the service of a partnership representative for partnerships and other entities treated as partnerships.
Major Differences between Old Rules and New Rules