Nathan Blackwell, CPA
Effective for tax years beginning in 2018, the new centralized audit regime for partnerships drastically changes the way partnership audits will be conducted by the IRS. Previously, under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) audit rules, if deficiencies were found in the partnership return which resulted in the incorrect pass-through of tax-related items to partners and the IRS wanted to assess these deficiencies against all the partners, the IRS had to open an audit proceeding against each of the partners separately.
Under the new audit rules, the IRS will audit and make assessments at the partnership level directly. With the new rules, individual partner audits will no longer be needed in order for the IRS to levy a tax assessment as a result of a deficiency found in a partnership return. Instead, the IRS will take the deficiency calculated and apply the highest individual rate applicable in the year of the deficiency to determine the tax. The tax will then be assessed against the partnership directly and appear as a non-deductible expense.
Another major change is the creation of the partnership representative. The representative may be an individual or an entity, though if it is an entity, an individual must still be specified. The representative does not need to be a partner of the partnership, so almost anyone can serve. The partnership representative is given wide latitude and power to act for the partnership during an audit. The partnership representative is the only individual with whom the IRS must communicate during the audit, and the representative possesses the legal authority to bind the partnership and the partners in regards to items such as agreeing to settlements, receiving and accepting notice of partnership adjustments, and making any appropriate elections related to the audit.
While a method does exist to allow partnerships to elect out of the new rules and continue to operate under the old rules, doing so is difficult because of the eligibility requirements. In order to elect out, partnerships must have fewer than one hundred partners and must not have any partners who are disregarded entities, partnerships, or trusts. If a partner is an S-Corporation, each of the shareholders of the S-Corporation count towards the one hundred partner limit, and all of them must also meet the eligibility requirement. These restrictions make it very difficult for most investment partnerships to elect out of the new audit regime since they generally have partners that are trusts or other partnerships.
An audit will generally take place several years after the year in which the tax return was filed. Once an audit does occur, it will take even more time to resolve. Consequently, a partnership will end up with tax, interest, and penalties for one tax year assessed in a later tax year. This could create a problem, whereby partners who should have paid the tax in a prior year may have already left the partnership and / or new partners may have joined. Because the partnership is now directly responsible for paying the tax out of partnership funds, this could cause a shift in the tax burden either by placing older tax burdens on new partners or shifting them from partners who have exited to the remaining partners or both.
The partnership can address this issue in several ways. The partnership representative can make an election to “push out” the tax assessed so that the partners from the tax year under audit pay the tax. Of course, the partners will not be able to challenge the tax assessment, meaning that partners who exited years prior may suddenly discover they have a tax bill, and one with higher than normal penalties since the underpayment penalty will be 2% more in this circumstance. The partnership representative could also ask for a modification of the assessment if there are appropriate factors, such as tax-exempt partners. They might also choose to accept the assessment and agree to pay it out of partnership funds.
If the partnership elects to pay the assessment, those partners currently in the partnership bear the responsibility for the tax since the assessment reduces the partnership assets in the year the tax is assessed. The partnership might address this by creating a claw-back provision in its partnership agreement, allowing the partnership to seek payments from former partners for their share of the tax or by creating a holdback on exiting partners’ payouts, retaining a percentage until the statute of limitations expires. The partnership representative may also decide that partners currently in the partnership must shoulder the burden. Regardless of the solution chosen, it should be specified in the partnership agreement so that all partners are clearly aware of the obligations they have.
The new position of partnership representative also has many issues that partnerships need to address. Under the new rules, the partnership representative’s authority cannot be limited by the partnership for purposes of dealing with the IRS, but the partnership agreement can provide limitations for investors to sue under state law for things such as breach of contract or fiduciary duty. In order to ensure that partnership representatives are handling matters in a method acceptable to investors, the partnership agreements need to provide language which addresses several concerns. Some key examples include:
- How is the representative chosen?
Since the partnership representative does not need to be a partner, virtually anyone can serve. Many fund managers, general partners, or other partnership leaders may not be the best choice to serve in this role as they might lack the necessary tax skills or be put into positions where they have to make decisions contrary to the interest of one or more of the individual investors, compromising their relationship with these investors. Investment companies need to carefully consider all their options and potential conflicts when designating who will serve.
- What level of independent decision making is the representative going to be allowed to wield?
Unlike in previous years, where each partner controls the decisions related to his or her personal audit, those decisions will now be made for the partner. The partner will not be able to challenge the agreement made by the partnership representative, so it will become imperative to address the input partners will have if any.
- What level of indemnity does the representative have?
Will the representative be indemnified, and if so, to what degree and under what circumstances. Since decisions made by the representative may benefit one or more partners and be less advantageous for other partners, it could create a situation where no matter the action of the representative, someone is adversely affected.
- What level of communication is going to exist between the partnership representative and the other partners?
The IRS will communicate with the representative. It could be entirely possible for an IRS audit to occur and many partners be totally unaware. What is the obligation of the representative and the partnership management to actively communicate with the partners, including former partners who might be affected by a push out or claw-back?
It is almost certain that in the next few years, these new regulations will increase the number of partnerships audited by the IRS. The advantages to the IRS are multi-faceted. In the past, a deficiency would have to be spread among the partners, and many were simply too small to warrant conducting dozens of individual audits. This problem is now eliminated since only one audit is required, significantly shifting the benefit versus cost ratio in favor of the IRS. Additionally, since assessments at the partnership level will be applied at the highest individual rate, more revenue will be generated from partnership audits than if the audit assessments are passed through to the partners. Finally, the IRS’ collection efforts are facilitated because it only needs to collect from one source instead of many. Preparing for the possibility of a future audit is essential now that the rules have changed.
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