Partnership Tax Audits: An Uncertain Future
In January, the White House announced a temporary freeze on new regulations, including proposed Internal Revenue Service (IRS) regulations clarifying new partnership audit rules that were enacted in 2015 and take effect next year. How does this affect partnerships? Although the proposed regulations are on hold, and it’s uncertain how the new administration’s review will affect them, the freeze doesn’t change the fact that the new audit rules are set to take effect on January 1, 2018, absent Congressional action.
A Brief Overview of the New Rules
The IRS and Treasury Department issued the proposed regulations on January 18, implementing a new “centralized” approach to partnership audits enacted by the Bipartisan Budget Act of 2015 (BBA), as amended by the Protecting Americans from Tax Hikes Act of 2015.
In a dramatic departure from current practice, the new rules will impose tax liability resulting from an audit adjustment at the partnership level rather than allowing it to flow through to partners in the year under examination (the “reviewed year”). What’s more, this so-called “imputed underpayment” will be calculated based on the highest individual or corporate tax rate for the reviewed year, without regard to partner-level tax attributes that would otherwise reduce their tax liability. And because the partnership must take this tax liability into account in the year an adjustment becomes final (the “adjustment year”), current partners may be responsible for tax liabilities that should have been borne by former partners.
The BBA and the proposed regulations provide two ways for partnerships to obtain relief from these harsh results: First, “small partnerships” can elect out of the centralized audit regime. And second, a partnership may avoid the rules by electing to “push out” tax adjustments to the responsible partners.
To elect out, a partnership must have 100 or fewer partners, all of which are eligible. An eligible partner is any individual, C corporation, foreign entity that would be treated as a C corporation if it were domestic, S corporation or estate of a deceased partner. Generally, a partnership meets the 100-partner threshold if it’s required to furnish 100 or fewer K-1s for the relevant tax year. However, special rules provide that 1) the shareholders of an S corporation partner count toward the 100-partner threshold, and 2) husbands and wives are not treated as a single partner for these purposes.
To push out adjustments to reviewed year partners, a partnership must file an election within 45 days after the IRS mails the final partnership adjustment (FPA), and it must furnish and file statements reflecting reviewed-year partners’ shares of the adjustment. A valid election shifts liability to the reviewed partners, who must increase their taxes for the year in which the statement is furnished by an amount that reflects the increased tax they would have paid in the reviewed year had the adjusted items been reported correctly.
Pushing out adjustments involves some time and effort, but because it allows for consideration of partner-level tax attributes, it has the potential to reduce the overall tax impact of an audit adjustment.
It’s uncertain how the new administration’s review will affect the partnership audit regulations. It’s also unclear whether lawmakers will modify or even eliminate the centralized audit regime. Between now and the end of 2017, partnerships should monitor legislative and regulatory developments. If the new rules go into effect as scheduled, partnerships should familiarize themselves with them and determine whether they’re eligible to elect out of centralized audits. Partnerships that will be subject to the new rules should weigh the costs of pushing out adjustments to reviewed year partners against the potential tax savings.