The New Partnership Audit Rules apply for tax years beginning in 2018, so be sure you have reviewed and updated your partnership agreements and limited liability operating agreements. The Bipartisan Budget Act of 2015, signed on November 2, 2015, made dramatic changes not only to the way the Internal Revenue Service audits partnerships but also to who is liable for any additional tax resulting from a partnership audit adjustment. The Bipartisan Budget Act of 2015 was a sweeping change. The implementation was delayed, giving time for taxpayers and the IRS to prepare for the changes, but now beginning with the 2018 tax year the new audit rules are in effect.
The basic tax concept of a partnership has been that the partnership return is an information return and all items of income, gain, expense, or loss flow through the entity to the individual partners. Each of the individual partners receives a statement from the partnership with the separate items to report on each partner’s separate income tax return. Under the new partnership audit rules, however, if there are any adjustments to the tax items, including penalties and interest, they will now be assessed and collected at the partnership level1. The partnership must pay the tax on any “imputed underpayment”. The additional tax on the imputed underpayment is determined by multiplying the imputed underpayment by the highest tax rate in effect for individuals or corporations2. The interest and penalties are calculated based on this additional tax which is derived using the imputed underpayment amount and assessed and collected against the partnership. This is significant because this “imputed underpayment” does not take into consideration the individual tax rates or situations of the individual partners and automatically assesses additional tax at the highest rate, and then compounds this fallacy by using this imputed amount as the basis to determine penalties and interest making the additional taxes, penalties and interest, the highest possible amount. Further, the IRS now collects the tax against the partnership entity, which has never before been a separate taxable entity (because partnerships have never been taxed at the entity level).
Each partnership, including limited liability companies which are taxed as a partnership, is required to designate a “partner representative”. The “partner representative”3 replaces the “tax matters partner”. In the event a partnership does not have a partner representative, the IRS may appoint one for the partnership. Under the new rules, the partner representative does not have to be a partner of the partnership. The partner representative represents the partners in an audit of the partnership return and has broad powers to bind the individual partners as to the amount and character of items and allocations reported on the individual’s personal tax return.
In addition to having any additional tax assessed automatically at the highest rate, there could be an issue with the timing and payment of the taxes if the partnership’s owners have changed or the partners’ percentage interests in the partnership have changed from the tax year for which the additional tax is assessed and the current year where the IRS is collecting payment. This should be addressed when the operating agreement is reviewed and amended to provide for the partner representative, otherwise, current partners may end up paying the tax on income already distributed to the previous partners (or paying a disproportionate share of the tax, if the partner percentages have changed). Many partnership or limited liability company operating agreements provide that the income distributions change each year according to capital accounts, which often change each year resulting in the income distribution changing each year.
Small partnerships where each of the partners are individuals, S-corporations, C-corporations, or the estate of a deceased partner may elect to opt out of the new audit rules4. Additionally, a partnership that is subject to the new partnership audit rules may elect to have its reviewed partners pay their distributive share of any adjustment, plus interest, if elected within 45 days of the notice of the final partnership adjustment5. However, there is a cost of electing the alternative to payment of imputed underpayment by the partnership and having the partners pay the tax rather than the partnership, the tax impact in the adjustment year is increased (but not decreased) by any adjustments attributable to years between the reviewed year and the adjustment year and the interest rate is 5% instead of 3%6.
The payment of additional tax or allocation of any refund, consideration of available elections relating to the audit provisions or payment of tax, and a requirement of providing each partner notice regarding an audit should be considered in the revisions to the operating agreements for partnerships and limited liability companies which are taxed as partnerships.
These important new tax provisions are just another reason to review your operating agreement regularly. Let us know if our tax and business professionals at Kinkead and Stilz can assist you or your clients with these or any other issues.
1. Internal Revenue Code Section 6621 (hereafter referenced as IRC 6621)
2. IRC 6625
3. IRC 6623
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