The Bipartisan Budget Act of 2015 (BBA), signed into law in November 2015, brings about major changes to the rules relating to IRS tax audits of partnerships. The BBA replaces the Tax Equity and Fiscal Responsibility Act (TEFRA) and the Electing Large Partnership (ELP) rules governing the IRS’s examination of partnerships.
Under the new rules, tax adjustments resulting from partnership audits will generally be assessed at the partnership level. This allows the IRS to collect tax due on partnership adjustments at the entity level, thereby imposing an entity-level tax on partnerships.The effective date of the new rules will begin with returns filed for tax years beginning after December 31, 2017. However, a partnership can elect to apply the new rules for returns filed before 2018.
The new rules apply to all partnerships regardless of size or number of partners, unless the partnership is eligible to elect out and does so in a timely manner.
The new rules allow for certain “small” partnerships to elect out of this new audit regime. Small partnerships generally:
Adjustments are made at the partnership level rather than the partner level
The new audit rules dictate that any adjustment to a partnership’s return and a partner’s resulting share of income or loss is determined at the partnership level. Unlike the current audit rules, however, all tax liability resulting from such adjustments will be assessed and collected at the partnership level rather than the partner level.
Partners’ tax burden is likely to increase under the new rules
Because the adjustments will be based on the highest tax rate regardless of the individual 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.
The role of “partnership representative” gains a new importance
The new audit rules do not allow partners to mount an individual defense of the tax position at issue. Instead, power will rest with the designated partnership representative, which does not need to be a partner, but 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.
Partners can be taxed for years in which they weren’t involved in the partnership
Because any 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. In other words, the economic burden of the tax very well might fall on partners who were not involved in the partnership when income was generated.
Partnership can elect to pass through adjustments to partners
The partnership may elect to have audit adjustments passed through to the partners, meaning that the obligation to pay the tax liability passes from the partnership to the partners.
To do this, revised Schedule K-1s reflecting audit adjustments are issued to those who were partners of the partnership during the tax year that was audited. Each partner in the audited year will then be required to reflect the adjustment on their personal income tax returns in the current year.
This method does not transfer the economic burden of the imputed underpayment to partners who were not parties to the economic agreement in the year under audit.
The new rules constitute a significant change from existing law and, pending additional guidance from the Treasury, leave many questions unanswered.
Prior to the effective date, partnerships should consider taking steps to assess the potential impact of the new rules on new and existing partnerships and partnership agreements. We also advise partnerships to determine whether they are eligible to opt out, and if so, evaluate whether it’s beneficial to do so.
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Published on February 08, 2016