A New Audit Regime
Late last year, we discussed how the IRS has found it increasingly difficult to audit partnerships as they have grown in number, size, and complexity, and to collect any resulting income tax deficiencies, especially in the cases of large partnerships and tiered partnerships.
We noted that, in response to these difficulties, Congress enacted, as party of the Bipartisan Budget Act of 2015 (“BBA”), a number of new tax compliance provisions. A key feature of the BBA is that it imposes liability for any audit adjustments with respect to an earlier partnership tax year on the partnership, rather than on those persons who were partners during the audited tax year.
Specifically, the IRS will examine the partnership’s items of income, gain, loss, deduction, and credit, and the partners’ distributive shares, for a particular year of the partnership (the “reviewed year”). Any adjustments (including interest and penalties) will be taken into account by, and will be collected from, the partnership – not from those who were partners during the reviewed year – in the year that the audit or any judicial review is completed (the “adjustment year”).
Under the BBA, a partnership with 100 or fewer partners is permitted to elect out of the new rules, in which case the partnership and partners will be audited under the general rules applicable to individual taxpayers. In that case, the reviewed year partners will take into account the adjustments made by the IRS, and pay any tax due as a result of those adjustments.
In order to qualify for this “small partnership” election, each partner of the partnership must be an individual, a C corporation, an S corporation, or the estate of a deceased partner.
It is likely that most qualifying partnerships will elect to be treated as small partnerships.
The new partnership audit regime enacted by the BBA will generally apply to returns filed for partnership taxable years beginning after December 31, 2017. The IRS is expected to issue additional guidance relating to the changes prior to January 1, 2018. This should afford partnerships the time to adjust to the new audit regime, and especially to the new default rules that apply to every partnership unless the partnership elects out.
That being said, a partnership may elect to apply these changes early, to any of its returns filed for partnership taxable years beginning after November 2, 2015 (the date of the enactment of the BBA) and before January 1, 2018.
Although it is unlikely that many partnerships will choose to be covered by the new audit regime before it becomes effective, there may be circumstances in which such an election may be considered.
For example, a partnership may choose to make this election to be eligible before 2018 to pay tax at the partnership level, to obviate the need to furnish amended Schedules K–1 to correct a partnership-level error, or to obviate the need for partners receiving amended Schedules K–1 to file amended income tax returns.
However, in light of the absence of any guidance regarding the operation of the new audit rules, it will be difficult for a partnership to determine whether such an election would, in fact, be beneficial.
Moreover, some partners may be concerned that the filing of such an election may be construed by the IRS as a signal that the partnership expects to be audited, that it may have something to “hide.”
The IRS recently adopted a temporary regulation (the “TR”) to provide the time, form, and manner for a partnership to make an election to have the new partnership audit regime apply early – to any of its partnership returns filed for a partnership taxable year beginning after November 2, 2015 and before January 1, 2018. A partnership that elects to apply the new partnership audit regime to a partnership return filed for an eligible taxable year may not elect out of the new rules under the small partnership exception with respect to that return.
The TR further provides that an election , once made, may only be revoked with consent of the IRS. In addition, partnerships may not request an extension of time for making the election.
Significantly, in order to allay the concerns described above, the TR provides that an election to have the new partnership audit regime apply must be made when the IRS first notifies the partnership in writing that a partnership return for an eligible taxable year has been selected for examination (a “notice of selection for examination”). In other words, the partnership can wait to make the election until it is notified that it is going to be audited.
A partnership that is so notified, and that wishes to make an election, must do so within 30 days of the date of the notice of selection for examination.
The election must include a statement that the partnership is electing to have the partnership audit regime enacted by the BBA apply to the partnership return identified in the IRS notice of selection for examination. The statement must be provided to the individual identified in the notice of selection for examination as the IRS contact for the examination.
Among other things, the statement must include representations that the partnership is not insolvent and does not reasonably anticipate becoming insolvent, the partnership is not currently and does not reasonably anticipate becoming subject to a bankruptcy petition under Title 11, and the partnership has sufficient assets, and reasonably anticipates having sufficient assets, to pay the potential underpayment that may be determined during the partnership examination.
In no case may an election under the TR be made earlier than January 1, 2018.
The examination rate among partnerships, including LLCs, has increased in recent years, and partnership audits are certain to increase at an even greater rate after the BBA’s changes become effective on January 1, 2018.
In the interim, it will behoove partnerships and their advisers to stay abreast of any guidance that the IRS issues regarding the application and implementation of the changes in the partnership audit rules.