The Bipartisan Budget Act of 2015 (the BBA) replaced the existing partnership audit rules with new procedures generally effective for partnership years beginning January 1, 2018. The new audit regime (the New Regime) substantially modifies how partnerships are taxed by making partnerships, and not the partners, liable for payments of any federal taxes assessed as a result of an audit at the partnership level. Top estate attorneys from The Morris Law Group continue the discussion below.
Changes Associated With the New Regime
The New Regime now provides a default rule that the partnership will be responsible for any resulting imputed underpayment in the event the IRS makes adjustments in an audit that increases the partnership’s taxable income or reduces the amount of a previously reported loss with respect to a reviewed year. The imputed underpayment, including additions to tax in the form of penalties that are to be determined at the partnership level, and interest, will be assessed against the partnership.
Prior to the New Regime, the IRS was required to collect any underpayment of federal income tax (including penalties and interest), owing as a result of an audit, directly from the partners and not the partnership. Thus, one of the primary effects of the New Regime is to relieve the IRS of the burden of having to pursue each partner to collect taxes assessed as a result of an income tax audit of the partnership.
Additionally, the New Regime requires a partnership to designate a representative to act on its behalf. Under the prior law, that representative was called the Tax Matters Partner. Under the New Regime, it is the Partnership Representative.
The Tax Matters Partner had to be a general partner and non-partners could not be elected even if that non-partner had the most knowledge of the partnerships matters. Section 6223 of the Internal Revenue Code has been amended as a result of the BBA to set the rules for the designation of a Partnership Representative. The Partnership Representative can be any person that has a substantial presence in the United States. The Partnership Representative can be a partner, non-partner, or other entity. If the Partnership Representative is an entity, the entity must appoint an individual to act on the entity’s behalf. This election is made on the partnership’s tax return each year. Once designated for that particular year, it remains in effect until terminated.
There is a limited exception for certain eligible partnerships to opt-out of the New Regime. Such an election may be made only if the following requirements are met: (i) the partnership has 100 or fewer partners, and (ii) each partner is an individual, a decedent's estate, a C corporation, an S corporation or a foreign entity that would be treated as a C corporation if it were a domestic entity. Currently, the opt-out election is not available to partnerships that have as a partner, another partnership, a trust, or a single-member LLC.
An eligible partnership may opt-out of the New Regime for a taxable year by making an election on its tax return (timely filed, with extensions) and notifying each of its partners within 30 days of making such an election. If no opt-out election is made, the New Regime applies to all partners in the partnership.
The Partnership Representative has the final say in its representation of the partnership in an audit. There are myriad issues that should be addressed in the partnership/operating agreement with respect to the New Regime including mandatory call provisions, ability to seek reimbursement from former partners who were partners during the audit years, how to treat non pro rata contributions to address the obligations that arise during the audit, etc.
The New Regime impacts every partnership and it is highly recommended that every entity taxed as a partnership for federal income tax purposes revise its Partnership/Operating Agreement to address the issues that arise with respect to the New Regime.
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