Partnerships, Part III: Partnership Audit Procedures
The Bipartisan Budget Act of 2015 changed partnership audit procedures in several ways.
Editor’s note: Part 1 of this series discussed the Tax Cuts and Jobs Act of 2017 as it pertains to carried interest and the loophole in filing partnership tax returns. Part 2 focused on the changes to the partnership net operating loss deductions under tax reform. Part 3 discusses the complexity of new partnership audit procedures that went into effect Jan. 1, 2018.
Related resources for H&R Block tax professionals:
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- How long does the IRS have to assess tax? What is the assessment statute expiration date (ASED)?
- Who may represent the taxpayer at an audit?
- What is a 30-day letter?
- What should be done if a 90 day letter is received during an audit examination process?
Before the Bipartisan Budget Act of 2015 (BBA), partnership audit procedures were difficult for the IRS to enforce because of the hefty administrative burden. The BBA simplified these rules and helped the IRS streamline the audit process by adopting centralized audit procedures that went into effect at the start of 2018. However, the previous partnership audit procedures still apply to tax years 2017 and earlier. Further complicating audit procedures, partnerships may opt out of the new rules and be subject to a third, even earlier, set of audit procedures.
This article discusses how additional tax due may be assessed, at what rate it is assessed and who is eligible to represent the partnership in the proceedings under prior law as compared to the new procedures under the BBA. The following rules and elections can be fairly complex; partners should consult a tax attorney to determine if they are eligible or if they should make adjustments to their partnership documents.
For tax years beginning before January 1, 2018, audit adjustments flowed through to individual partners
For tax years 2017 and earlier, partnership audits are governed by the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). TEFRA subjects partnerships to a single unified proceeding, meaning the IRS cannot make any adjustments to partnership items during an individual partner’s audit. When the unified proceeding is completed, the IRS issues a final partnership audit adjustment (FPAA) describing any required adjustments.
Any adjustments from the FPAA flow through to the partners’ returns which then need to be adjusted. The IRS assesses any additional tax due on the partners’ returns at each individual partner’s tax rate without reference to the other partners’ rates. The IRS adjusts the partners’ returns as if there were a computational error without going through the normal proceedings. The only way the partner can dispute the adjustment is by paying any amount due and filing a refund claim. It is important to note that these adjustments only apply to partnership items, which are determined at the partnership level such as partnership income and expenses.
Prior to the BBA, the Tax Matters Partner represented the partnership in audit proceedings
Under the pre-BBA procedures, the Tax Matters Partner (TMP) represents the partnership throughout the unified proceedings. The TMP has the power to enter into settlements with the IRS that are binding on all the partners. If the partnership does not appoint a TMP the IRS has the authority to do so. Finally, the TMP must be a domestic general partner, i.e. U.S. citizen, of the partnership at some point during the year in which the TMP designation is made.
To illustrate, Jane is a member of the JJB Partnership along with 11 other partners, all of whom are U.S. citizens. In 2017, the partnership’s 2015 return was audited using the TEFRA procedures resulting in adjustments to partnership items. Jane, the partnership’s TMP, settled with the IRS on behalf of the partnership. Since Jane’s settlement as TMP was binding on all the partners, the adjustments flowed through to the partners’ individual returns as computational adjustments by the IRS. The partners would either accept the changes or pay the tax due and amend their 2015 returns to initiate a refund action.
For tax years beginning after December 31, 2017, additional tax liability is assessed against the partnership
The new audit rules under the BBA took effect on January 1, 2018, and they apply to tax years beginning after December 31, 2017. Unlike the TEFRA rules where any additional tax flows through to the partners, the BBA shifts the liability to the partnership. The BBA created two concepts that are important when determining who is liable for paying any tax: the reviewed year and the adjustment year. The reviewed year is the year that is being audited, i.e. tax year 2015 in the above example. The adjustment year is the year in which the actual adjustment is made, i.e. tax year 2017 in the above example.
The distinction is important because, under the BBA, the partnership is responsible for paying any tax liability imposed from an audit which means the partners in the adjustment year bear the burden of the tax, as opposed to the reviewed year partners as under TEFRA. This result aligns with other partnership responsibilities; for example, when a partnership has an outstanding liability, the partners are generally liable for paying it out of their share of partnership property.
Example: Jane sells her entire partnership interest in JBB under the BBA
Imagine that Jane sold her entire partnership interest in JBB, including her share of partnership liabilities, on January 1, 2019 to Kelly. The partnership’s 2018 return (reviewed year) is audited in 2020 (adjustment year) and adjustments were made imposing a tax liability on the partnership. The adjustments would not flow through to Jane under the BBA because JBB is responsible for paying the tax under the new law, and she no longer holds an interest in JBB. Kelly would likely bear some of the burden of the liability because she is generally liable for her share of partnership debts. Note that this tax will be assessed at the highest individual rate under the BBA instead of the partners’ rates.
If the partners in the adjustment year do not wish to bear the burden of audits for years prior to their ownership, they may elect to “push out” the adjustments to those who were partners in the review year. Simply put, the partnership would not be liable for the tax and the reviewed year partners would be liable for the tax, penalties and interest. This election must be made within 45 days of the date that the IRS mails a final partnership adjustment to the partnership.
Assume that in the previous example JBB elects to push out the adjustments. In that case, Jane would be liable for her share of the adjustments since she was a partner in the reviewed year. Thus, Kelly would be insulated from any tax liability from the audit of JBB’s 2018 return.
After the BBA, the partnership representative replaces the tax matters partner in the audit process
Another deviation from the TEFRA is that the BBA eliminates the role of TMPs and creates the partnership representative (PR). Unlike TMPs, PRs no longer must be a partner, rather, they can be any person who has a substantial presence in the United States. This requirement is satisfied if the PR is available to meet in person with the IRS, has a U.S. street address, telephone number and a taxpayer identification number. PRs have the sole authority to act on behalf of the partnership, and their decisions are binding on the partnership.
Eligible partnerships that do not wish to be subject to the BBA regime may opt-out. If the partnership does opt-out, it will only be subject to an audit if an individual partner’s tax return is audited. It is important to note that if the partnership opts out of the BBA regime it will not be subject to the TEFRA regime, but rather the pre-TEFRA rules. An eligible partnership is one that has no more than 100 eligible partners for the entire taxable year. Eligible partners can be
- C corporations,
- Certain foreign entities,
- S corporations, or
- Estates of deceased partners.
If any of the partners is a partnership itself, trust, disregarded entity, nominee, estate (other than one of a deceased partner) or an ineligible foreign entity, it is precluded from opting-out of the BBA regime. From the example, because JBB’s partners are all individuals and there are only 12 of them, the partnership could opt-out of the BBA regime. For more information on opting out of the new audit procedures see TD 9829.