The New Audit Regime

Thomas R. Tartaglia, CPA (Feb, 2018)

On November 2, 2015 “The Bipartisan Budget Act of 2015” (BBA) was signed into law by then President Obama. As part of this legislation the existing rules for auditing large partnerships were changed and replaced with new rules that went into effect January 1, 2018. 

The new audit rules are very different from the rules in effect prior to 2018. Currently partnerships are required to pay taxes and penalties, rather than pass them along to their partners. The new rules are not designed to increase fairness or reduce the burden on existing partners; they are meant to assist the IRS in auditing large partnerships.

Tax Treatment of Partnership Items - Tax Years Beginning Before 1/01/18

Partnership audit procedures prior to the enactment of “BBA”:

Under pre-Act law, partnerships could be audited under three different regimes: the unified audit rules, the small partnership rules, and the electing large partnership rules.

  • Under the Tax Equity and Fiscal Responsibility Act (TEFRA) unified partnership audit rules, the tax treatment of any partnership item (and the applicability of any penalty, addition to tax, or additional amount that relates to an adjustment to a partnership item) is generally determined at the partnership level. For most partnerships with more than 10 partners, the IRS conducts a single administrative proceeding to resolve audit issues regarding partnership items that are more appropriately determined at the partnership level than at the partner level. Once the audit is completed, the IRS will recalculate the tax liability of each partner in the partnership for the particular audit year. The IRS must assess any resulting adjustment against each of the taxpayers who were partners in the year in which the misstatement of tax liability arose.
  • Any partnership having 10 or fewer partners, each of whom is an individual (other than a nonresident alien), a C corporation, or an estate of a deceased partner, the IRS generally applies the audit procedures for individual taxpayers, auditing the partnership, and each partner separately.
  • Simplified audit procedures apply to large partnerships with 100 or more partners that elect to be treated as electing large partnerships for reporting and audit purposes. Under these electing large partnership audit and adjustment procedures, the IRS generally makes adjustments at the partnership level that flow through to the partners for the year in which the adjustment takes effect. The current-year partners' share of current-year partnership items of income, gains, losses, deductions, or credits are adjusted to reflect partnership adjustments that take effect in that year. Adjustments generally will not affect prior-year returns of any partners. A partner in an electing large partnership is not allowed to treat partnership items on his return inconsistently with the partnership return, even if he notifies the IRS of the inconsistency. Unlike the TEFRA partnership rules, only the partnership can request a refund. The partners of an electing large partnership do not have the right to participate in partnership-level administrative proceedings. Also, the IRS does not need to give notice to individual partners of the beginning of an administrative proceeding or a final adjustment. Instead, a notice of partnership adjustments is generally sent to the partnership, and only the partner designated by the partnership may act on behalf of the partnership. In addition, the electing large partnership rules allow for simplified reporting to the IRS.

Tax Treatment of Partnership Items - Tax Years Beginning After 12/31/17

Partnership audit procedures:

The new law. The BBA prospectively repeals the current TEFRA uniform partnership audit rules. The Act similarly repeals the electing large partnership rules. These rules are replaced with a streamlined single set of rules for auditing partnerships and their partners at the partnership level. The new rules generally apply to partnership tax years that begin after December 31, 2017. However, except for the election-out rules for small partnerships, partnerships may elect (as directed by the IRS) for the changes to apply to any return of the partnership filed for partnership tax years beginning after November 2, 2015 (the Act's date of enactment) and before January 1, 2018. An election is valid only if it is made under the rules described by the IRS.  Once made, it may not be revoked without IRS consent.

Key changes effective with the “BBA” are as follows:

  • Adjustments to a partnership’s items of income, gain, loss, deductions and credits will be made at the partnership level.
  • Any tax or additional amounts due will be determined and collected at the partnership level (unless an alternative election is made). The partnership can elect to provide a statement of adjustment to each partner who was in the partnership in the year under audit (called a “push–out” election).
  • Underpaid taxes will be calculated at the highest individual or corporate rate in effect for that year.  
  • Partnership audit adjustments are made in the current year, not the year(s) under audit, unless the partnership elects to file amended Schedule K-1's. Therefore, new partners in existing partnerships can bear the tax burden for adjustments to prior year tax returns, unless a “push-out” is elected.
  • A partnership must designate a partner (or other person) as the partnership representative, who has the sole authority to act on behalf of the partnership for the audit. The partner must have a substantial presence in the United States. All partners, as well as the partnership, are bound by the actions taken by the designated partner at any time during the audit, as well as any final decision during any audit-related proceedings. If the partnership does not designate a representative, the IRS is allowed to select “any person” with a substantial presence in the United States as the representative.

Exception for Small Partnerships

Electing out of the post-2017 partnership audit procedures:

An eligible partnership can elect out of the centralized partnership audit regime. An eligible small partnership consists of:

  • 100 or fewer partners, as measured by the number of Schedule K-1's it is required to provide to partners.
  • All of the partners who receive a Schedule K-1 must be eligible partners for the entire tax year. Eligible partners are individuals, C corporations, eligible foreign entities, S corporations, and estates of deceased partners.
  • For purposes of the 100 or fewer partners’ requirement, a partnership that has an S corporation as a partner must take into account each Schedule K-1 that the S corporation is required to provide to its shareholders. Thus, an S corporation partner that has 50 shareholders will count as 51 partners against the 100 partner limitation (one statement is required to be provided by the partnership to the S corporation plus 50 statements that the S corporation must provide to its shareholders).

Once this election is made, it can be revoked only with IRS consent. 

Caution: An otherwise“eligible” small partnership will not qualify for the election out if they have a partner that is a partnership, or an LLC treated as a partnership.

When to Elect

The election is made on a timely filed partnership tax return (including extensions).

How to Elect

A statement must be included with the partnership’s federal income tax return that contains all of the required information about each person that was a partner at any time during the partnership’s tax year, and in the case of an S corporation partner, the shareholders of such S corporation. The information required to be disclosed about each partner includes the partner's name, taxpayer identification number, federal tax classification, an affirmative statement that the partner is an eligible partner, and any other information required by the IRS in forms, instructions, or other guidance. In addition, the partnership must notify each partner within 30 days of making the election.

Document Title

ELECTION E212: Election out of Centralized Partnership Audit Regime for Small Partnerships

What you should do under the new Partnership Audit Regime:

1. Review your partnership agreement and update it to reflect the new regulations.

-          Acknowledge the new enactment.

-          State the partnerships intent to elect out of the revised partnership audit rules if eligible.

-          Select a partnership representative. This does not need to be a partner (the new audit rules do not provide for a tax matters partner). At a minimum, all partnerships should do this step.

-          Set procedures for choosing the partnership representative.

-          Set guidelines for the sharing of IRS correspondence by the representative to the partners. The representative is not obligated to share any IRS correspondence with partners unless the partnership agreement is amended to require him/her to do so.

-          Determine if a “push out” election should be made.

2. Elect out of the revised partnership audit rules if eligible.

All partnerships and entities treated as a partnership should review and, if necessary, modify their partnership agreement to reflect these changes. The tax professionals at Dermody, Burke & Brown are available to assist you in complying with these new complex audit rules.

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