The Bipartisan Budget Act of 2015 established a new “centralized audit” regime for partnerships, including LLCs taxed as partnerships. although the audit rules apply to partnership tax returns for tax years beginning after 2017, the IRS didn’t finalize regulations on these rules until December 2018. This article reviews the new audit rules and discusses steps partnerships should take if they’re audited.
The Bipartisan Budget Act of 2015 established a new “centralized audit” regime for partnerships, including LLCs taxed as partnerships. Although the new audit rules apply to partnership tax returns for tax years beginning after 2017, the IRS didn’t finalize regulations on these rules until December 2018.
A quick refresher
Here’s a brief review of the new audit rules. Most significantly, the rules are designed to shift many of the burdens associated with auditing partnership returns from the IRS to the partnership itself, and its partners. They do this by allowing the IRS to determine tax adjustments- and assess any additional taxes, penalties and interest (at the highest marginal individual or corporate tax rate)- at the partnership level.
The IRS now has the authority to assess and collect taxes from the partnership on these “imputed underpayments” without having to consider partners’ circumstances or tax attributes that might reduce their individual tax liabilities. That burden is now imposed on the partnership, which may 1) seek a modification of an imputed underpayment by demonstrating that is should be taxed at a lower rate or by having partners file amended returns and paying the resulting tax, or 2) electing to “push out” partnership adjustments to the relevant partners.
On risk associated with the new audit regime is that, unless partners from the tax year being audited are held responsible for imputed underpayments, new partners may end up paying tax liabilities that were the responsibility of former partners.
Final regulations narrow scope of new rules
One significant provision of the final regs narrows the scope of items subject to adjustment under the centralized audit regime. Although proposed regs would have allowed the IRS to adjust a broad range of items connected to a partnership, the final regs limit an audit’s scope to items that 1) appear (or are required to appear) on the partnership’s tax return, or 2) are required to be maintained in the partnership’s books and records.
So, for example, an individual partner’s outside basis in a partnership interest wouldn’t fall within the scope of a partnership audit, even if the partnership chooses to maintain that information in its books and records.
The final regs also set forth complex procedural rules, including rules for requesting modifications of imputed underpayments and making a push out election.
Steps partnerships should take
There are many steps partnerships can take to minimize the impact of the new audit rules. First, a partnership should determine wither it’s eligible for the “small partnership election.” This allows it to opt of the centralized audit regime and follow the old audit rules, under which the IRS generally assesses and collects taxes at the individual partner level.
Your partnership is eligible to opt out if it has 100 or fewer partners, all of which are qualifying partners. Qualifying partners are individuals, C corporations (including foreign entities that would be treated as C corporations if they were domestic), S corporations or estates of deceased partners. If your partnership has just one non qualifying partner (such as a partnership or trust) it can’t opt out, regardless of its size.
It’s also a good idea to amend your partnership agreement to facilitate actions that can reduce the impact of the new audit rules. For example, you might amend the agreement to:
- Require current or former partners to furnish tax information or file amended returns in the event of an audit,
- Require the partnership to make a push out election in the even of an audit, or
- Indemnify partners against tax liabilities that were the responsibility of former partners.
You should also update the agreement to establish procedures for selecting a partnership representative and set forth the representative’s duties and responsibilities to the partnership.
Turn to your advisor
All partnerships should familiarize themselves with the final regulations and take steps to protect themselves in the even of an audit, including opting out of the new rules if they’re eligible. Contact your tax advisor for additional information.
Jeffrey A. Faltys, CPA
Jeffrey joined Hancock & Dana in 2017 as a staff accountant. With five years of experience in public accounting, Jeffrey has a wide range of experience including tax preparation and planning services for individual, closely held business, and non-profit clients. Jeff also assists in audits of governmental, non-profit and for-profit non-public entities, as well as other attest engagements.
His experience also includes general bookkeeping, preparation of quarterly payroll tax returns and general business consulting projects.