The Bipartisan Budget Act of 2015 (BBA) included a provision which created new partnership audit rules. Partnerships (including LLCs taxed as a partnership) are subject to the new rules starting this year. The new rules were implemented in order to decrease the time required for the IRS to complete an audit, thus allowing more entities to be audited.
The first significant change is the creation of the “taxpayer representative” to replace the tax matters partner. Under the new rules the taxpayer representative has a more important role to play. Partners other than the taxpayer representative will no longer have the right to participate in a partnership audit or judicial proceeding. Partners will not even be notified by the IRS that the partnership is being audited or be able assist in the partnership’s defense.
Interestingly, the taxpayer representative does not have to be a partner in the partnership. The selection of the taxpayer representative is very important not only for the reason above, but the taxpayer representative will also be the individual responsible for informing the IRS if any of the elections discussed below will be used in the event of an IRS audit.
Because of the importance of the taxpayer representative we suggest that partnership (or LLC taxed as a partnership) agreements should be modified to indicate who will serve as the taxpayer representative, how they can be removed, and how a new taxpayer representative will be determined.
Now for the really drastic changes. Under the new rules, any charges determined by the IRS in the course of a partnership will be made at the partnership level and the charges will be assessed to the partnership in the year that the audit (or a judicial review) is completed. This means that the current partners will be “on the hook” for charges and penalties, even if they were not a partner during the year(s) being audited.
Furthermore, the amount of the tax will be calculated at the highest marginal rate for individuals or corporations.
Unless… the partnership elects one of the following exceptions.
- Small Partnerships – The new rules do not apply to “small partnerships.” Small partnerships must meet two criteria. First, they must have 100 partners or less. Second, the partners can only be individuals, estates, C corporations, S corporations, and/or foreign entities that would be C corporations if they were a domestic entity. That means if any of the partners are trusts (including a revocable grantor trust), a single member LLC, or partnership (i.e. tiered partnerships), the partnership will not qualify as a small partnership. The partnership must make the election to “opt out” of the new audit rules on a return that is filed in a timely manner. The partnership agreement should be adjusted to indicate that a qualifying partnership is going to make such an election.
- Push-Out Election – A partnership can elect out of the new audit rules, but this requires that the partnership send amended K-1s to all former partners. Note that the partnership, not the IRS, will need to send out the amended K-1s. Partnerships wishing to make this election must send out the amended K-1s with 45 days of receipt of the notice of a partnership adjustment. To avoid any misunderstandings by the taxpayer representative we believe the partnership agreement should be amended if the elect out option is desired.
- Tax Rate Adjustment – As indicated the IRS will assess any additional tax at the highest corporate or individual rate. However, the partnership’s taxpayer representative will have an opportunity to demonstrate to the IRS that some or all of the assessment should be at a lower rate.
This article is only a brief overview of the new partnership audit rules. If you have any questions regarding how the new rules could affect you should you be audited, and what changes to your partnership agreements might be appropriate, contact our Tax Department at 781-407-0300.