New partnership audit rules are now in effect for partnership years beginning on or after January 1, 2018. The new partnership audit rules are complex and require careful decisions to be made by the partners, so it’s important to understand them along with their potential impact on your organization.
Under the new partnership audit rules, referred to as the Centralized Audit Regime (CAR), the IRS audits the partnership’s items of income, gain, loss, deduction, credit, and the 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 that the audit or any judicial review is completed.
In the past, many partnership audits were conducted in accordance with the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). Under a TEFRA audit, administrative procedures were made at the partnership level and any corresponding collections of resulting tax due were assessed at the partner level, with the IRS making adjustments to the partners’ returns.
Overview of New Rules
Under CAR, the general rule is that any audit adjustment resulting in an underpayment of tax—including interest and penalties—will be collected at the partnership level at the highest applicable income tax rate at the time of assessment.
A partnership, however, may request that the IRS impose a lower tax rate by timely demonstrating that some or all of the partners would actually pay tax at a lower rate if, for example, the income would have been taxed as capital gain income to the partners, or the partners consist of lower tax rate partners such as C corporations or tax-exempt entities.
Elections for CAR Audit Adjustments
As an alternative to this general rule of the partnership directly paying the underpayment, a partnership may timely elect to push out these audit adjustments to its reviewed-year partners within 45 days of receiving a notice of final partnership adjustment (NFPA). These audit adjustments are passed through to the reviewed-year partners on a statement similar to an amended Schedule K-1 and must be furnished to the reviewed-year partners within 60 days of the final determination of these adjustments. The reviewed-year partners would then report the audit adjustments on their tax returns for the tax year in which the NFPA is issued. As a toll charge for the convenience of utilizing this election, the underpayment interest rate on these adjustments increases by 2%.
Another potential alternative for partnerships required to pay an underpayment resulting from a CAR audit is referred to as a pull-in election. This allows the reviewed-year partners to pay the tax due under an amended tax return filing procedure without actually filing amended returns.
The pull-in election allows the partnership to reduce its imputed underpayment by the amounts the partners paid, provided the pull-in election is timely elected by the partnership with proof of payment by the affected partners of the resulting additional tax liability within 270 days after the date of the notice of proposed partnership adjustment is mailed.
Similar to the pull-in election, reviewed-year partners may file complete amended returns and pay all resulting tax liabilities.
Under TEFRA, partnerships were required to have a designated tax matters partner. This has been replaced by a partnership representative (PR), which has broad powers including the sole authority to bind the partnership and all partners with respect to any proceeding under CAR.
As a practical matter, the partnership agreement may limit the power of the PR; however, the new audit regime affirmatively states that the partnership agreement can’t restrict the powers of the PR. Any limitations or provisions in the partnership agreement are purely a matter of contract law between the partnership and its partners.
The PR can be an entity or an individual. If an entity is selected to be the PR, the partnership must also designate an individual to conduct the PR’s responsibilities. The PR or designated individual must have a substantial presence in the United States, including a US street address, phone number, and tax identification number as well as the availability to meet with the IRS domestically.
Opt-Out of CAR
Partnerships with 100 or fewer eligible partners may elect to opt out of CAR. This opt-out election is made annually on a partnership’s timely filed tax return for any particular year.
Once made, traditional audit, assessment, and collection statutes of limitation apply to the partners of electing partnerships for that year. A partnership isn’t eligible to elect out if one or more partners are other partnerships, trusts or disregarded entities.
Preparing for the CAR
In light of these new rules, partners may want to carefully consider amendments to their partnership operating agreement. Most partnerships will find it necessary to amend their partnership agreements. They should also carefully review their existing operating and governing agreements with their legal advisors because document neglect could lead to disputes in later years. It’s important to be proactive in reviewing agreements to prevent future controversies.
Considerations for Partners and Partnerships
While the following isn’t an exhaustive list, it highlights some of the key considerations for partnerships and partners with respect to the ramifications of CAR, which can be far-reaching.
Consider the following:
- Designation of the PR and designated individual, if applicable, and the roles and responsibilities of the PR including any limitations thereon.
- If eligible, whether the opt-out election should be made and how the decision is made—at the discretion of the PR or by a partner vote, for example. Also whether there are any collateral consequences of an opt-out election.
- If the PR should have the flexibility to decide whether the partnership should push out partnership adjustments or pull in tax payments.
- Who—the managing partner or designated management committee, for example—has the right to remove a partnership representative and how any vacancy in the position should be filled.
- If there should be a mandatory capital contribution to cover the professional fees of hiring tax professionals to assist in a partnership-level audit.
- If cash or property should be retained by the partnership upon the redemption of a partner to cover professional fees or any potential tax liability for a reviewed year in which the redeemed partner was a partner in case the partnership doesn’t make an opt-out or a push-out election.
- The impact of a partnership-level tax payment and how it should be taken into account for purposes of the distribution and allocation provisions in the partnership agreements.
- Notification policies and procedures the PR should follow in informing the partners at the beginning of any audit proceedings and the findings during, or at the conclusion of, the audit.
- Whether the roles and responsibilities of the PR should be limited under the partnership agreement.
We’re Here to Help
To learn more about evaluating the implications of these new audit rules and how we can work with you and your legal advisors to evaluate potential changes to your operating agreement, contact your Moss Adams professional.