By  and

Featured, Analysis, October 2017 Issue |
November 2017

Get Copyright Permission

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.

Partnership Representative

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)].

Consistency Requirement

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)].

Effective Date

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.

EXHIBIT

Major Differences between Old Rules and New Rules

Old Rules; New Rules What is a large/small partnership?; Small partnerships have 100 or fewer partners, with no partnerships or S corporations as partners, and have not elected to be treated under TEFRA or ELP. TEFRA partnerships have 10 or more partners and do not meet small partnership rules. Electing large partnerships (ELP) have 100 or more partners or elect to be treated as a large partnership.; Electing small partnerships (ESP) must provide no more than 100 K-1s, and all partners must be one of the following entities: individual, C corporation, foreign entity that would be a C corporation under U.S. law, S corporation, or the estate of a deceased partner. They may annually elect out of the new rules on timely filed returns with proper notification to all partners. No partnerships with over 100 partners, a partnership as a partner, or no valid small partnership election (large partnerships) may elect out. Which entity is audited?; For small partnerships, the partnership return is audited as an adjunct to the audits of partners' returns. Under TEFRA and ELP, audits are conducted on “partnership items” at the partnership level.; ESPs are treated the same as small partnerships under old law. Large partnerships are audited at the partnership level on all items (no longer a distinction between partnership and affected items). At what level are partnership audit adjustments made?; Partner level for smaller partnerships. Under TEFRA and ELP rules, at the partnership levels.; No change Which entity pays taxes, interest, and penalties?; Small and TEFRA partnerships do not pay taxes, interest or penalties; partners do. ELPs can elect to pay imputed underpayment (see below for further discussion). ELP is responsible for interest and penalties.; No change for ESPs (other than definition of small partnerships). Large partnerships pay taxes, interest, and penalties, then allocate these amounts to the partners unless election is made to file amended K-1s for the reviewed year. What is the function of the tax matters partner/partnership representative?; Small partnership partner already acting as its own representative. TEFRA partnership must designate a tax matters partner to liaise with the IRS. ELP must designate a partner (or other person) as partnership representative. IRS can designate.; ESPs treated the same as small partnerships under old law. For large partnerships, each partnership must designate a partner (or other person) with a substantial presence in the U.S. as the partnership representative. IRS can designate if partnership does not. Who has authority to act on behalf of the partnership with the IRS or courts?; In small partnerships, each partner acts on its own behalf in deficiency proceedings. For TEFRA partnerships, each partner has the right to participate in administrative proceedings and can request separate adjustments/refunds, which must be consistent with any settlement reached on partnership items. After administrative adjustment phase, generally only tax matters partner may file petitions with the court. ELP partners have no right to participate in settlement conferences or request separate refunds.; ESPs treated the same as small partnerships under old law. Partnership representative only for large partnerships. Who has the right to receive commencement and final adjustment audit notices from the IRS?; Each of the partners in a small partnership. For TEFRA partnerships, each partner has the right to receive notices (some exceptions if more than 100 partners). In ELPs, each partner does not have the right to receive separate notices. Notices are sent to the last known address of the partnership.; ESPs treated the same as small partnerships under old law. For large partnerships, only the partnership or partnership representative has the right to receive notices. Notices are sent to the last known address of the partnership or representative. Can a partner take a position inconsistent with the partnership return?; Generally no—small and TEFRA partners are required to report items consistently with the partnership return. However, with proper notification to the IRS of the inconsistency, it is possible to take an inconsistent position. No—ELP partners are required to report items consistently with partnership return. ; ESPs treated the same as small partnerships under old law. For large partnerships, generally not—but yes with proper notification to IRS; rules similar to old TEFRA rules. TEFRA =Tax Equity and Fiscal Responsibility Act of 1982

Sharon K. Burnett, PhD, CPA, CISA is Edwards Professor of Accounting at the College of Business, West Texas A&M University, Canyon, Tex.
Darlene Pulliam, PhD, CPA is a Regents Professor and McCray Professor of Accounting at the College of Business, West Texas A&M University, Canyon, Tex.

Related posts