In recent years, the popularity of partnership filings have increased as this entity type has grown. Partnerships provide a number of key benefits to business owners, including flexibility as well as operational, legal, and tax benefits. The IRS however, has found it both costly and burdensome to audit partnerships, and in particular, large partnerships. The IRS audit rate of large partnerships, for instance, is less than one percent. By comparison, in 2012, 27% of large corporations were selected for audit.
The difficulty for the IRS is that every partner in a partnership has a different set of circumstances, and sometimes there are multiple tiers of entities that the IRS has to work through, issuing adjustments and assessments along the way. The desire to better scrutinize partnerships and increase government revenue has led to the centralized partnership audit concept enacted by section 1101 of the Bipartisan Budget Act of 2015, and amended by the Protecting Americans from Tax Hikes Act of 2015.
While the final regulations have yet to be released, it’s important to know now what’s changing, as the proposed regulations are set to be effective for all years beginning after December 31, 2017.
The new default rules make the partnership liable for an imputed underpayment of tax based on adjustments at the partnership level. In many cases this could create overall higher tax liabilities because there’s no consideration for each individual partner’s tax situation. To avoid this scenario, eligible partnerships can make an “opt out” election to avoid these new audit procedures. To do this, the partnership must have 100 or fewer eligible partners. Eligible partners are individuals, C and S corps (each S-corp shareholder counts as one of the 100 partners), any foreign entity that would be treated as a C-corp if it were a domestic entity, or an estate of a deceased partner.
Trusts are not eligible partners, however, it is conceivable that grantor trusts may be eligible. Tiered partnerships may not elect out, unless it is the top tier, and all partners are eligible partners. The election is made each year with a timely filed tax return.
Another election available to partnerships is the “push-out” election to avoid the default rules and mitigate the proposed tax liabilities. With a push out election, the partnership “pushes out” the tax liability to the partners, who pay the tax by filing amended individual tax returns.
Additionally, the new rules replace the Tax Matters Partner designation with a Partnership Representative role. If the partnership does not have a designated Representative, the IRS can assign someone to this role and prohibit the partnership from selecting a new Representative without their consent. This Representative would have sole authority to make binding decisions on behalf of the partnership.
In light of this, taxpayers should give serious consideration to updating their partnership agreements to both, select a Representative, and require that Representative to seek consent from all partners prior to making any decisions or elections with the IRS on the partnership’s behalf. In another words, the powers that are to be given to the representative is a critical decision. While only one person can be the representative, the partnership agreement can make the powers as broad or narrow as agreed by the partners (for example – Can the representative unilaterally extend the statute of limitations, hire outside advisors to assist with the audit, or settle the audit?).
Until the final regulations are released, details on how to elect out, designate the partnership representative and other matters will not be known with certainty, and we won’t know the full impact for taxpayers. None the less, reviewing the proposed rules and discussing potential implications with your attorney and CPA is highly advisable. Contact a member of the Barnes Dennig team here, or call 513-241-8313 if you have any questions.