The Bipartisan Budget Act (“Act”) was signed into law on November 2, 2015 amending the rules concerning how entities taxed as partnerships will be audited by the IRS and who is required to pay the tax resulting from audit adjustments.
Under the current regime, entities taxed as partnerships do not generally pay income tax but rather report their taxable income and losses on Form 1065 U.S. Return of Partnership Income. The partnership then provides each partner with a Schedule K-1 which the partner utilizes to report their share of income and loss from the partnership on their individual tax return and pay the corresponding tax. Currently, under procedures enacted as part of the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”), audits of partnerships are conducted under the following scenarios:
- For partnerships with ten or fewer partners, audits are conducted of the partnership itself and of the partners individually;
- For partnerships with ten or more partners, the audit is conducted under uniform TEFRA procedures at the partnership level and is binding on the taxpayers who are partners during the year under audit; and
- Partnerships with 100 or more partners, at the election of the partnership, audits may be conducted under uniform “Electing Large Partnership” procedures, whereby the audit is conducted at the partnership level and is binding on taxpayers who are partners at the conclusion of the audit.
Under the current regime, audit adjustments are made by the IRS at the partnership level with respect to any tax year under audit. Under the new regime, the IRS will assess and collect from the partnership rather than the partners any underpayment of tax, calculated at the highest corporate or individual income tax rate in effected during the year under review.
The new regime will take effect for entities taxed as partnerships for tax years beginning on or after January 1, 2018. Under the new rules, each partnership must appoint a Partnership Representative (“PSR”). The PSR has sole authority to act on behalf of the partnership for the purposes of the new rules. If no PSR is appointed, the IRS will appoint a PSR for the partnership.
The partnership itself is directly liable for any related penalties and interest. This change means that the burden of tax assessments resulting from audits will fall on persons who are partners in the adjustment year rather than persons who were partners during the year being reviewed. The act does allow for an alternative payment election where the liability to pay any assessment is transferred to the reviewed-year partners rather than the partners in the adjustment year. Such an election must be made no later than 45 days after the date the partnership receives the notice of audit adjustments and may only be revoked with the IRS’s consent. While the election shifts the burden of assessment to the reviewed-year partners, it effectively precludes any partner from challenging the assessment. The details of the methodology surrounding the alternative payment election have not yet been created by the U.S. Treasury Department.
A partnership is eligible to elect out of the new audit regime, if the partnership issues 100 or fewer K-1’s for the tax year and each of the partners during the tax year are any of the following:
- An individual;
- A C corporation;
- A foreign entity that would be treated as a C corporation if it were domestic;
- An S corporation; or
- An estate of a deceased partner.
If, during the tax year, any partner was not one of the above entities or issued greater than 100 K-1s, it may not elect out of the new audit regime.
Much of the application of this new regime is still unknown at this point and will become clearer as guidance is released in the form of Treasury Regulations.