The Bipartisan Budget Agreement Act of 2015, signed into law by President Obama on November 2, 2015, completely overhauls the current audit procedures that apply to entities taxed as partnerships. The new law is generally effective for partnership taxable years beginning after December 31, 2017. It repeals and replaces existing rules for partnership audits.
Because many entities organized as limited liability companies are taxed as partnerships, this law is expected to affect many limited liability companies, as well as entities organized as general or limited partnerships. Given its wide reach, it is important for tax professionals and business owners to be aware of this new law and the upcoming changes to IRS audit rules. These new rules will radically simplify the ability of the IRS to audit and make adjustments to partnership returns.
The stated objective of the new legislation is to increase the number of partnership tax audits. Indeed, the legislative history notes that large corporations are currently audited at the rate of 27.8% every three years, while the current audit rate for large partnerships is only 0.8%.
Like the current audit rules, the new audit rules provide that any adjustment to a partnership’s return and partners’ resulting shares of income or loss is determined at the partnership level. Unlike the current law, however, once the new rules become effective, taxes and penalties associated with such adjustments will be assessed and collected at the partnership level, rather than the partner level.
Because the adjustments will be based on the highest tax rate regardless of the partners’ respective tax rates, partnerships may be liable for substantially more taxes and penalties than the partners would be liable for if adjustments were made at the partner level.
Additionally, because the adjustments will be taken into account in the year in which the audit or judicial review is complete, rather than the year to which the adjustment relates, the economic burden of an adjustment and any penalties may be shifted from those who were partners in the partnership when the issue arose to those who are partners in the year of the adjustment.
A partner who fails to treat any items consistently with the audit result and who does not satisfy one of the very narrow exceptions to this rule will be subject to an assessment of deficiencies by the IRS as a mathematical or clerical error. In such circumstances, the partner will not be entitled to any adjustment with respect to the determination.
The new audit rules apply to all partnerships, regardless of size. The new rules include “opt-out” procedures for partnerships with less than 100 partners where all the partners are either individuals, C-corporations, foreign corporations that would be treated as C-corporations if they were domestic, S-corporations, or estates of a deceased partners. As a result, all partnerships that have as a partner an entity taxed as a partnership are not eligible to opt out of the new rules. As such, tiered partnerships will be subject to the new rules, unless the Treasury develops regulations to the contrary.
The new audit rules do not permit partners to mount an individual defense of the tax position at issue. Power will instead rest with the designated “partnership representative,” which need not be a partner, but which must have a substantial presence in the United States. Both the partners and the partnership will be bound by the actions taken by the partnership representative.
A partnership representative may be designated either by the partnership or the IRS (if the partnership has not done so). The Treasury has not yet published guidance for designating the partnership representative.
The new law leaves many questions unanswered. While the Treasury is tasked with developing guidance regarding many key issues, there is no guarantee that it will do so in a timely manner.
No immediate action is required at this point. We are monitoring developments closely and will follow up with additional recommendations as issues become clearer. But you should anticipate that existing operating and partnership agreements will need to be amended no later than the end of 2017 in order to address these issues.
Again, we will follow up with recommendations as the scope and application of these important new rules become clearer. If you have any questions regarding the new audit rules, please contact the authors.