Authored by Paul Dillon, Mark Heroux, Michelle Hobbs and Michael Wronsky
The IRS reissued Bipartisan Budget Act of 2015 partnership audit regulations on June 14, 2017 (the new partnership audit regime). These regulations are binding on partnerships effective for partnership tax years that begin after December 31, 2017. The new regulations require changes to every partnership agreement. Partnerships are well-advised to review and change their partnership agreements in accordance with the requirements of the new guidelines. The regulations also may impact partnerships’ financial statements as they can now potentially have deferred tax exposure under ASC 740.
The new regulations create a partnership tax liability
A partnership is a flow-through entity that does not pay income taxes — until now. The new regulations dictate tax resulting from partnership adjustments made pursuant to an IRS exam will be assessed against and collected from the partnership. The assessment will be made in the year that the adjustment is made (the adjustment year) and is payable with the filing of the partnership’s Form 1065, U.S. Return of Partnership Income for the adjustment year. The new regulations provide a complex system of rules that allow the partnership to push out the assessed liability to partners of the partnership during the year under review by the IRS (the reviewed year) or to have the assessed liability allocated to partners of the partnership in the adjustment year. But unless the partnership can elect out of the new regime, there will be a tax assessment against what has heretofore been a nontaxable entity. Taxpayer-favorable adjustments do not produce a refund to the partnership but are reported as Schedule K-1 adjustments to adjustment year partners. However, partners during the review year may likely argue the favorable adjustments should be reported to them. The partnership agreement needs to provide certainty here, which will likely require an amendment since this issue has never needed to be addressed before.
Electing out of the new partnership audit regime
The new regulations apply to all partnerships. Partnerships that issue 100 or fewer Schedules K-1 that do not have any partnership (tiered partnership structure) or trust partners can elect out of the new regime, in which case, the IRS exam will take place at the partner level. Partnerships elect out by making an annual election on a timely filed Form 1065. Partnerships with partnership or trust partners will want to review their structure to see whether a restructuring can position the partnership to elect out of the new regime.
The partnership representative
The new partnership audit regulations require partnerships identify a partnership representative. This is different than the previous tax matters partner (TMP). The partnership representative has sole authority to act on the behalf of the partnership. The partnership representative controls the IRS exam, decides whether and when to extend the statute of limitations, whether to accept a settlement, and whether to agree to an adjustment. In short, every major decision related to an IRS exam is made by the partnership representative. Consultation with any of the partners is not required by statute or the new regulations. The partnership representative must raise penalty defenses regardless of whether the defense relates to the partner or the partnership. The partnership representative may be a firm. If the partnership agreement does not identify a partnership representative the:
- the IRS can appoint a partnership representative for the partnership; and
- the IRS’s appointment is not a reviewable decision.
Partnerships are well advised to identify a partnership representative in their operating agreements or to provide a process in the partnership agreement for appointing the partnership representative. The appointment should not be left to the IRS.
Planning consideration: Consider putting limitations on the acts of the partnership representative, e.g., the partnership representative cannot accept a settlement offer without first obtaining the approval of 60 percent of the partners. The partnership representative is identified in the annually filed Form 1065.
Planning consideration: Consider having the partners form another entity to act as the partnership representative in case of an audit. This could provide partners’ input into the decision of the partnership representative.
Modifications to the partnership adjustment (the amended return option)
Partnerships that cannot elect out of the new regulations will need to make several decisions that will affect the outcome of a prospective IRS exam, and these decisions should be memorialized in the operating agreement. The first option is to use amended returns to modify the IRS’s proposed partnership adjustment. The regulations call for the IRS to reduce the proposed partnership tax assessment to the extent that the partnership can show that individual partners in the reviewed year filed amended returns reporting the transactions at issue consistent with the IRS’s position, or would be willing to file amended returns consistent with the IRS’s position.
Planning Consideration: Consider revising partnership agreements to require partners to submit amended returns to address proposed IRS partnership adjustments to reduce any proposed partnership tax assessments.
The push-out election
The new regime also mandates that IRS exam adjustments to a review year return will be assessed against the partnership in the adjustment year. The regulations allow partnerships to “push out” the adjustment year assessment to review year partners. The regulations indicate that the partnership makes an election to use this method to satisfy partnership tax assessments. The election must be made no later than 45 days after the date the IRS issues notice to the partnership of the partnership adjustments.
The new audit regulations specify that when using the push-out method, the partnership furnishes each review year partner and the IRS a statement indicating the partner’s share of any adjustment. The partnership does not pay the partnership assessment; each partner instead takes the allocable share of the adjustment into account on the partner’s adjustment year tax return. The entire amount of the proposed assessment must be satisfied by pushing out the liability to the partners (no splitting of the assessment between the partnership and the partners).
Whether a partnership will push out a prospective IRS assessment against the partnership should be part of the partnership agreement. Partnership agreements should clearly state which partners will be subject to future IRS exam assessments. In addition to changes in the operating agreement, partnerships may have to provide indemnifications to current or prospective partners so partners that were not partners in the review year are not subject to liability for future IRS exam assessments. Purchase and redemption agreements may change as a result of the new regulations. Escrow agreements may come into play to reserve funds for prospective partnership tax assessments.
ASC 740 implications
The new partnership audit regulations will require partnerships conduct an ASC 740 review of their transactions. Going forward, partnerships will need to analyze their tax positions to see if they meet the more-likely-than-not standard, and potentially record a deferred liability for — and identify in the income tax disclosure — positions that do not meet this standard. This will be a significant change from just including a disclosure that partnerships pass through their liabilities to its owners. Even if the transaction meets the more-likely-than-not standard, the posting of a reserve may still be necessary because ASC 740 imposes limitations on the largest amount of the benefit a taxpayer can report on transactions that meet the more-likely-than-not standard. Consequently, a reserve and related disclosure may still be required for transactions that meet the more-likely-than-not standard. This is a seismic change for partnership financial statement audits.
Planning Consideration: For partnerships with financial statement implications, begin planning for your disclosures now by identifying positions that could give rise to disclosures under ASC 740. The required analysis can be extensive and complex, and should be addressed accordingly when planning financial statement audit or review engagements.
As states evaluate the impact of the new federal audit rules, there are several issues to consider. First, each state will determine whether it will conform to the federal rules, so it is likely there will be multiple adaptations of these rules at the state level. Currently, only Arizona has adopted them with different treatment depending on the audit outcome.
Second, the IRS will increase its information sharing with the states, but only with the state listed in the taxpayer address on the federal return. Consequently, it is unclear how additional states in which the partnership files will obtain audit changes made to its returns.
Third, it may be necessary to have a different partnership representative for each state that may also be different from the federal partnership representative. As a result, the terms and definitions of the partnership representative may become even more complex if the partnership operates in multiple states.
Fourth, the process to make adjustments may vary by state. Certain states may require amendment of prior year returns while others may allow current year adjustments, and others may require a push-out of adjustments to the partners.
Other areas of consideration include: type and year of any state apportionment changes, apportionment versus allocation of audit adjustments, adjustment treatment between taxable and tax-exempt partners, and the impact to nonresident withholding requirements.
Partnerships are well-advised to consider the changes imposed by the new audit regulations, and review and make changes to operating and other agreements before the start of 2018. Do not wait until December to get your partnership agreements modified. Let all partners know the rules of the game that apply beginning January 1, 2018. Current and prospective partners will want to know exactly how partnerships plan to address the new rules. Take note, even the smallest family partnerships should at least amend their partnership agreements to identify the partnership representative.
For more information on this topic, or to learn how Baker Tilly specialists can help, contact our team.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.