Partnerships are the flexible, familiar form of business entity used to organize and manage investors and their projects. As the result of 2015 federal tax legislation, enterprises that use partnerships should consider problems not anticipated by their agreements, in case of IRS audit.
Looking back, the soon-expiring TEFRA partnership audit regime, named after the Tax Equity and Fiscal Responsibility Act of 1982, was not very successful in helping the IRS find unreported taxable income hiding in partnership tax returns. The audit process was cumbersome for the IRS, and litigation was prevalent in disputes regarding what was a partnership item subject to a partnership audit and what was a partner item subject to the audit of an individual partner.
The Taxpayer Relief Act of 1997 tried to provide a fix for large partnerships, but to no avail. Meanwhile, the number of entities being taxed as partnerships has been growing. A Government Accountability Office report from 2014 found the number of large partnerships, defined as having 100 or more direct and indirect partners and $100 million of assets, increased to 10,099 from 2,832 between 2002 and 2011.
Seeking to capture lost tax revenue, the Bipartisan Budget Act of 2015 eliminates the partnership audit procedures as we know them and implements supposedly streamlined partnership audit procedures. Get ready, because the new centralized partnership audit regime is effective for tax years beginning after Dec. 31 this year. There's an option to elect in early, but I know of no client who's made it.
In Partnerships 101, aspiring tax professionals learn partnerships are "pass-through" entities; they don't pay tax, but rather pass through items of income, gain, loss, deduction, or credit to the eventual taxpayer. The new rules change that: An IRS audit can turn partnerships into taxpayers responsible for "imputed underpayments," the formal language for IRS audit adjustments that increase tax. And the rate used to calculate that tax? The higher or the highest individual rate (currently 39.6%) or the corporate rate (35%). And before you ask, that payment is nondeductible. There's an election to have the tax assessed at the partner level to audited-year partners, but the underpayment penalty associated with the tax due is two percentage points higher with that option.
One of the questions I ask a client when preparing a new partnership tax return is, Who is the tax matters partner? Not anymore. The new rules require partnerships to designate a partnership representative – "PR" – to be point person with the IRS on audits, among other things.
The PR need not be a partner, but must have a substantial U.S. presence. The PR can bind the partners and partnership to settlements with the IRS, final audit adjustments, and court judgments. If a partnership fails to designate a PR on the partnership's tax return for the year in question, the IRS may designate one.
There's an option to elect out of the new centralized partnership audit regime. If done, the IRS must follow the rules of auditing individual taxpayers to audit the elected-out partnership. To be eligible for this yearly election, the partnership must issue 100 or fewer K-1s and must not have partners that are partnerships or trusts. The latter will disqualify a good number of the partnerships in my practice.
What can be done to prepare for these rules? Determine who will be your PR and what accountability the PR will have to the partners. Also consider what protections the PR will have from the partners. Consider if you are eligible to elect out of the new regime and whether it's a good idea to do so. Contemplate indemnification clauses in your partnership agreement, binding partners to be responsible for tax during years they are partners, even if the tax is assessed in later years. And, do your diligence when joining a partnership to ensure the above, at least, has been addressed.
Proposed regulations for the new law appeared in the Federal Register on June 14. A first draft was made available in January. However, due to the Trump administration's regulatory freeze, the regulations were never officially published. On June 13, the American Institute of Certified Public Accountants asked the Treasury and IRS for a one-year delay in implementing the rules.
To delay implementation, Congress would have to act.
Randy Garcia is a CPA. He's writing this column on behalf of the Fort Worth CPAs, a regular contributor to FW Inc.