How to Prepare for the New Partnership Audit Rules

Effective for taxable years beginning after December 31, 2017, the Centralized Partnership Audit Regime (CAR) enhances the IRS’s ability to audit partnerships and collect tax.

Enacted as part of the Bipartisan Budget Act of 2015 (BBA), the CAR applies to all entities required to file Form 1065, US Return of Partnership Income. Entities that file this return must make critical decisions regarding the following actions:

  • Considering amendments to partnership agreements
  • Electing out of the CAR
  • Electing to push out or pull in adjustments
  • Appointing a partnership representative

Background

Prior to the BBA, partnership audits were generally conducted following the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). Under a TEFRA audit, administrative procedures were made at the partnership level. Any corresponding tax collections were then assessed at the partner level with the IRS making any necessary adjustments to partner returns.  

Under the CAR, the IRS may now collect tax, including penalties, at the partnership level. The new rules contain the following provisions:

  • Partnerships must annually designate a partnership representative that has broad powers to bind the partners and partnership for any proceeding with the IRS under the new rules.
  • Entities required to file a partnership return are subject to the CAR, although certain partnerships may have the ability to elect out.
  • Partnerships ineligible to otherwise elect out may push out the audit adjustments to their partners through a statement similar to an amended Schedule K-1.
  • Partnerships required to pay an underpayment may also elect to use the pull-in election, which allows some or all reviewed-year partners to pay the tax due under an amended tax-return filing procedure without filing amended returns.

Partnership Representative

The CAR replaces the role of tax matters partner with the partnership representative. The partnership representative has broad powers, including the sole authority to bind all partners with respect to any proceeding with the IRS under the CAR.  

As a practical matter, a partnership agreement may limit the power of the partnership representative, however, the CAR states that a partnership agreement ultimately can’t restrict a partnership representative’s power before the IRS.   

A partnership representative can be an entity or an individual. If an entity is chosen, the partnership needs to select a designated individual to conduct the partnership representative’s responsibilities.

A partnership representative must have a substantial US presence, which includes the following:

  • Availability to meet with the IRS in the United States
  • US street address
  • US phone number
  • US tax-identification number

Once designated, the partnership-representative role is effective for that tax year, unless it’s formally revoked by notification to the IRS. It’s also worth noting the role may expose the partnership representative to personal liability.

Opt-Out Election

All entities filing a partnership return are subject to the new audit regime, however, certain eligible partnerships can elect out. An eligible partnership must have 100 or fewer partners, with each required Schedule K-1 counting toward that threshold.

The ability to elect out is available only if all partners are eligible partners:

  • Individuals
  • C corporations
  • Real estate investment trusts
  • Eligible foreign entities treated as corporations
  • S corporations, which must count each shareholder when determining the number of partners
  • Estates of any deceased partners

A partnership with ineligible partners can’t elect out of the CAR. These include the following:

  • Partnerships
  • Disregarded entities, such as single-member LLCs
  • Foreign entities that aren’t otherwise eligible
  • Nominees
  • Estates (other than any deceased partners)

The opt-out election must be made on each timely filed annual tax return, and all partners must be notified within 30 days of making the opt-out election. Electing out of the CAR must be carefully considered before being pursued.

We’re Here to Help

There are many issues for your partnership to navigate now that the new audit rules are in effect, such as:

  • Considerations around updating your partnership agreement to reflect new audit rules, partnership-representative roles and responsibilities, possible election provisions, partnership taxes, and exiting partners
  • Understanding of the annual opt-out election and the consequences of electing out even if your partnership is eligible
  • Timely filing of any elections under the new rules

If you have further questions or would like to learn more about how the changing audit regime will affect you or your partnership, contact your Moss Adams professional.