Changes to Partnership Audits and Agreements
The Internal Revenue Service’s new Partnership Tax Audit Rules took effect for tax years beginning on or after January 1, 2018. Partnerships (including LLCs that elect to be taxed as partnerships) should be aware of these new rules and consider adopting the required and optional amendments to partnership agreements or member operating agreements to reflect the new tax regime. As discussed below, decisions will have to be made before the filing of your 2018 partnership tax returns.
Changes Under Centralized Partnership Audit Regime (CPAR)
The new centralized partnership audit regime has significantly changed the procedures for partnership audits in order to streamline the process. In general, the audit will take place at, and any adjustments will be taken into account only at, the partnership level. Any taxes assessed will be paid by the partnership at maximum rates – not by the individual partners. The “Tax Matters Partner” under the repealed TEFRA rules is replaced with a new name and a new concept altogether – a “Partnership Representative”. The partnership representative is the sole authority to act on behalf of the partnership in the event of an IRS audit. All partners, as well as the partnership, will be bound by the actions taken by the partnership representative at any time during the audit. Please note that partnerships in existence before the effective date must retain the “Tax Matters Partner” language in the partnership agreements until the statute of limitation expires for audits under years governed by TEFRA.
The partnership representative is designated on the Form 1065 for each year. Anyone who has substantial presence in the U.S. can be a partnership representative, this includes an individual, an entity, a disregarded entity, or the partnership itself. If an entity is selected, the partnership must then appoint a designated individual to act on behalf of the partnership representative.
Certain eligible partnerships may elect out of the CPAR with a valid election on a timely filed return. A partnership is only eligible to elect out if it has 100 or fewer partners and all partners are either an individual, a C corporation, an S corporation, or a deceased partner’s estate. Therefore, tiered partnerships with partnerships, disregarded entities, or trusts as partners do not qualify. Eligible partnerships that make the election out will be audited at the partnership level, however any adjustments related to an audit would be made in separate partner level proceedings, in accordance with prior law.
Push Out Election
If the partnership cannot elect out of CPAR, complications may arise if the partners in a year under audit are different than the partners in the adjustment year, resulting in current partners bearing the tax cost of decisions in which they did not participate and may have only benefited former partners. Partnerships should consider allowing the partnership representative to make a push-out election. If the election is made, the partnership would no longer be responsible for imputed underpayment. Rather, the reviewed year partners (including former partners) will bear the cost of adjustments for that year, including their share of tax, interest, and penalties.
In light of these new tax laws, changes need to be made to existing partnership agreements. Please note that these new IRS rules do not require partnerships to amend their agreements, however, we recommended that you do so. We have identified four areas to consider changing:
1. Designate a partnership representative: Partners should discuss a procedure for selecting the designation. Given the broad power a partnership representative will have under examination, partners should discuss and be aware of all the implications of this change. As preparers of your return, we cannot assume that a former Tax Matters Partner will be the same person as the appointed Partnership Representative for 2018.
2. Define the role of the partnership representative: From the IRS perspective, a partnership agreement will not limit the authority of the partnership representative. However, provisions and language should be put in place in the agreement to better define the obligations of decision making on behalf of the partnership. Because partnerships and partners will be bound by the decisions of the partnership representative under audit, we recommend that a revised agreement will require pre-approval of material decisions with great impact. This will provide protection for current partners. Additionally, the partnership agreement should include how other partners will be notified and participate in an examination in the event that one occurs.
3. Contribution requirements: The current year partners of a partnership may be different from the partners in a prior tax year selected for audit. If audit adjustments are made for any tax year beginning on or after January 1, 2018, revised partnership agreements should provide for whether a former partner from a previous year under audit should be responsible for their share of the liability of the partnership if underpayment is calculated. If this is not included in the agreement, current year partners will bear the entire tax cost of the adjustment and resulting underpayment, regardless of whether they were partners in the year under review. Consider also including this language in the redemption and purchase of partnership agreements as well.
4. Information sharing: A requirement should be included in the agreement which provides for certain information to be shared by the partners to the partnership representative coordinating with the IRS. This information is especially important if there are former partners in the year under audit who are no longer associated with the partnership. The information will be required should the partnership desire to make a push out election and “push” the financial burden to the partner level.
Please contact us to discuss in greater depth these changes and the current year implications for your partnership.
Written by: Kelly Mayer, CPA