Changes to Partnership Audit Procedures – Will this Affect You or Your Business?

By: Amber Stevenson

The IRS has issued proposed regulations (Centralized Partnership Audit Rules, also known as “CPAR”) regarding how audit adjustments related to partnership tax returns will be assessed.  If you own an interest in a partnership or an entity taxed as a partnership, or even if you used to own an interest in one of these types of entities, this could affect you and it’s important to be aware of the changes so you aren’t surprised by a tax bill down the road.

Beginning with returns filed for the 2018 tax year, new rules will allow the IRS to audit partnerships at the entity level and collect taxes directly from the partnership rather than tracing the adjustments up through the returns of the partners and assessing tax at the partner level.  At first glance, you may be thinking “that’s great, the tax won’t come out of my pocket!”  But is that true?  What happens if the partnership doesn’t have the funds to pay the tax?  It’s possible they could ask for capital contributions from the partners to pay the tax, or maybe future distributions will be decreased.  Or what if you’re a newly admitted partner and the year under audit was prior to your admission to the partnership?  If there’s nothing in the partnership agreement to suggest otherwise, you could be on the hook for taxes related to a year you weren’t even a partner.  Just because the tax isn’t being assessed directly against the partners, doesn’t mean the partners won’t be paying for it in the long run.  In fact, the tax that the partnership is required to pay could be even more than the combined payments of the partners if the adjustments were assessed at their level!  The new rules state that the IRS multiplies the net adjustment by the greater of either the highest corporate or individual ordinary income tax rate.  Currently, the highest individual tax rate is greater than the highest corporate tax rate at 39.6%.  Unless all of the partners are in the top tax bracket, the partnership is going to owe more than if each of the partners reported the income individually.  This is especially true if any of the net adjustment is capital gain income which would be taxed at lower, favorable rates at the individual level.  The burden is then on the partnership to prove to the IRS that a lower rate is more appropriate and the IRS has the discretion to accept or deny the request.

Another issue to consider is that if there are positive adjustments made during the audit (i.e., increased income), and the IRS assesses tax against the partnership, the partners do not get an increase to their outside basis for the increase in income.  The result?  Double tax!  And what happens if the net adjustment is negative (i.e., more deductions)?  Well in that case, the IRS does not calculate a refund due to the partnership or partners, but instead requires the net decrease in income to be reported in the “adjustment year” which means the year of the assessment.  In effect, this cheats any former partners, who no longer hold their interest in the partnership, out of their share of the loss because the loss ends up reported on a tax return from which they don’t get a K-1.

So, is there anything that can be done to help partnerships and partners avoid these unfavorable consequences?  In some cases, yes.  Let’s walk through three options that partnerships have in the face of the new rules:

• Under certain circumstances, partnerships can elect out of CPAR. The election is made annually with a timely filed Form 1065. The election must include a disclosure of each partners’ name and identification number and the partners must be made aware of the election within 30 days of making it.  If the election is properly made, the IRS must audit and assess tax at the partner level.  Of course, there are conditions that must be met in order to qualify to make the election.  First, the partnership must have 100 or fewer partners.  For these purposes, each K-1 counts as one partner, a husband and wife count as two partners (even if they receive only one K-1), and if an S-corporation is a partner, each of its shareholders count as individual partners.   Additionally, since each S-corporation shareholder counts as a partner, each of those shareholders must be included in the disclosure of the partners discussed above. The second requirement is that the partnership cannot have an “ineligible partner.”  Ineligible partners include other partnerships, trusts (including grantor trusts), single-member LLCs and nominees.
• The second option is for the partnership to issue a “push-out” statement within 45 days of the notice of final adjustment issued by the IRS. The push-out statement essentially says that those partners who owned interests during the year under audit, not the partnership, are liable for the tax. If this option is elected, the IRS will assess the tax, penalties, and interest against the partners.  The caveat here is that the interest will be assessed at a rate 2% higher than the normal IRS interest rate.  Outside basis will be adjusted for the income increase, however, which avoids the double taxation.
• The third option is for one or more partners to file amended tax returns within 270 days of the partnership receiving the notice of partnership proposed assessment (NOPPA). The tax, penalties and interest (at the usual IRS rate, not increased by 2%) paid by the individual partners reduces the amount owed by the partnership and the partners receive outside basis increases for the additional income reported on the amended returns.

Now that we know what options partnerships have, who gets to make the final decision as to which path the partnership takes?  Beginning in 2018, there must be a Partnership Representative (PR) appointed.  The PR will essentially replace what we used to refer to as the Tax Matters Partner, or TMP.  The PR will have the authority to represent the partnership before the IRS and make binding decisions to which all partners must adhere.  The PR can be, but does not have to be, a partner and they must have substantial U.S. presence.  A PR will be appointed by the IRS if the partnership does not select one.  Partnerships would be wise to select their own PR rather than allowing the IRS to select someone who may not take the partners’ best interests into consideration.

These regulations are still proposed and could change before they are issued final, but with only a few months left before the 2018 tax year begins, what should partners be thinking about to prepare themselves and their businesses for a future audit?  Amendments to partnership and operating agreements should be considered to allow or disallow electing out, include requirements to permit electing out, assign a PR, discuss the effect on partner interest changes or liquidation of the partnership, etc. Differences between federal and state treatment should also be considered.  As of today, Arizona is the only state that has conformed and issued audit rules and procedures similar to CPAR.  Of course, we will update this posting if and when these regulations become final.  Please contact us if you would like to discuss how these upcoming changes may affect you.