August 17, 2017
Clifton Larson Allen, LLP
The Bipartisan Budget Act of 2015, signed into law on November 2, 2015, amends the Internal Revenue Code and makes significant changes in the manner in which the Internal Revenue Service (IRS) audits partnerships. In general, the Budget Act repeals partnership audit procedures per the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) and replaces them with new audit procedures that apply by default to all partnerships. The new provisions are effective for partnership returns filed for tax years beginning after December 31, 2017. Proposed regulations (Reg -136118-15) were issued on January 18, 2017, but were never officially published as a result of the regulatory freeze announced by the White House on January 20, 2017. The Proposed Regulations were re-released on June 13, 2017, with minor modifications.
Under the new audit provisions, the tax on audit adjustments imposed by IRS on partnership items of income, gain, loss, deduction, or credit is assessed and collected at the partnership level. If the partnership does not elect to pass an adjustment through to its partners, (discussed later), the adjustment is determined with respect to the “reviewed year” (the year under audit) but is paid by the partnership in the “adjustment year” (the year the audit is finalized by IRS). Therefore, adjustments will be borne by the adjustment-year partners rather than by the reviewed-year partners even if the adjustment-year partners were not partners in the reviewed-year.
Election to pass partnership adjustments through to partners
IRC Section 6226 and Proposed Reg. 301.6226-1provides an alternative to the general rule that the partnership must pay the tax on the adjustments at the partnership level. With a proper election, the partnership can “push-out” the adjustments to the reviewed-year partners rather than directly pay the tax on the adjustments. The election can be revoked only with the consent of IRS. The election must be made within 45 days of the mailing of the final partnership adjustment (FPA) and, if the FPA has more than one adjustment, the election must identify which adjustments the partnership is electing to push-out. Thus, a partnership is allowed to elect to push-out only some of the adjustments.
Electing out of the centralized audit rules
Proposed Reg. 301.6221(b)-1 provides that an eligible partnership may elect out of the centralized audit regime. A partnership is an eligible partnership if it has 100 or fewer partners during the year and, if at all times during the tax year, all partners are eligible partners.
The determination of whether the partnership has 100 or fewer partners is made by counting the number of statements required to be furnished under IRC Section 6031(b) (generally Schedule K-1). A husband and wife are not treated as a single taxpayer. Any statements required to be furnished by an S corporation partner for the tax year of the S corporation ending with or within the partnership’s tax year are taken into account for purposes of determining whether the partnership is required to furnish 100 or fewer statements for the tax year.
Proposed Reg. 301.6221(b)-1(b)(3)(i) defines the term “eligible partner” as any person who is an individual, C corporation, eligible foreign entity, S corporation, or an estate of a deceased partner. Therefore, a partnership (lower tier partnership) that has a partner that is a partnership (upper tier partnership) cannot elect out of the centralized audit regime. The upper tier partnership can elect out if it is otherwise eligible.
A partnership makes the election only on a timely filed partnership return (including extensions) for the partnership tax year to which the election relates. The partnership must disclose to IRS the names, correct taxpayer identification numbers (TINs), and federal tax classifications of all partners of the partnership and, if there is an S corporation partner, the names, correct TINs, and federal tax classifications of all persons to whom an S corporation partner is required to furnish statements during the S corporation partner’s taxable year ending with or within the partnership’s tax year at issue. Additional information may be required by IRS in forms and instructions.
A partnership that elects out must notify each of its partners that the partnership made the election within 30 days of making the election. The notice may be in writing, electronic, or other form chosen by the partnership. Presumably, the notice can be made on Schedule K-1 or on a statement attached thereto.
Role of the Partnership Representative
Proposed Reg. 301.6223-1 provides rules requiring a partnership to designate a partnership representative and rules describing the eligibility requirements for a partnership representative. A partnership must designate the partnership representative on the partnership’s return filed for the partnership taxable year and must designate a partnership representative separately for each taxable year. IRS will notify a partnership if it is determined that a designation of partnership representative is not in effect for a tax year and allow the partnership to designate a representative. If the partnership does not designate a partnership representative within 30 days of the notification by the IRS, the IRS will designate a partnership representative on behalf of the partnership.
The partnership representative does not need to be a partner but must have a substantial presence in the United States. Proposed Reg. 301.6223-2(c) provides that the partnership representative has the sole authority to act on behalf of the partnership in any examination. Generally, no partner (except for a partner who is the partnership representative) may participate in or contest the results of the examination or other proceeding involving a partnership. The partnership representative is responsible for managing all phases of the IRS audit including gathering the information needed to contest a proposed IRS adjustment.
The authority of the partnership representative includes:
- Binding the partnership and partners to an adjustment or settlement in an IRS audit or in a related court proceeding;
- Deciding whether or not to seek judicial review of the proposed IRS adjustment and which court to use to seek judicial review;
- Choosing whether or not to extend the statute of limitations for reviewed years;
- Choosing whether to push-out the underpayment tax liability to the reviewed year partners under IRC Section 6226.
The fate of the partners is in the hands of the partnership representative and can result in a conflict of interest if the partnership representative is also a partner.
Example: Assume WXYZ Partnership in which W, X, Y, and Z share profits and losses equally (25% each). X is the partnership representative. WXYZ Partnership does not qualify to elect out of the centralized audit rules. The partnership is audited in 2020 for calendar year 2019. The partnership receives a final partnership adjustment in 2020 setting forth an increase in taxable income of $32,000 and a tax liability of $12,000. Partner T became a partner on 1/1/2020 by purchasing a 40% interest, 10% from each W, X, Y, and Z.
No push-out election
Partner Liability Percent Tax
W $12,000 15% $1,800
X $12,000 15% $1,800
Y $12,000 15% $1,800
Z $12,000 15% $1,800
T $12,000 40% $4,800
Total 100% $12,000
Partner Liability Percent Tax
W $12,000 25% $3,000
X $12,000 25% $3,000
Y $12,000 25% $3,000
Z $12,000 25% $3,000
T 0 0 0
Total 100% $12,000
As partnership representative, it would not be in Partner X’s economic interest to make the push-out election. As shown in the above example, new Partner T will be charged with a tax expense for a year that he/she was not a partner if the push-out election is not made.
It may be possible at least to some extent to limit the scope of the partnership representative’s authority. Some commentators have suggested that the partnership agreement include requirements to provide notice to partners of all significant IRS communications, to obtain approval of the partners before taking major actions, and require an election under IRC Section 6226 to push-out a proposed increase in tax to the reviewed year partners. It is important to note that Proposed Reg. 301.6223-2(c)(1) provides that the authority of the partnership representative to bind the partnership cannot be overridden by the partnership agreement. If the partnership representative takes a position in direct violation of the partnership agreement, the only recourse for the partnership and the other partners may be to bring an action against the partnership representative. Some have speculated that the new audit rules will result in more litigation between partners and representatives than between the IRS and partnerships.
Partnerships, and their advisors, need to give serious thought to their choice of partnership representative. In some situations, the best choice may be to appoint a non-partner as the partnership representative.