While celebrating the passage of the Protecting Americans from Tax Hikes (PATH) Act at the end of 2015, and the pleasant surprises it contained extending many taxpayer-friendly provisions, you may have missed something buried in the Bipartisan Budget Act of 2015 signed into law on November 2, 2015. This “something” is a dramatic change to the way partnership tax returns will be audited by the IRS beginning in 2018 and will impact every partnership and limited liability company (LLC) taxed as a partnership.
So what’s the big deal? Starting in 2018, these new rules will replace current audit rules and allow the IRS to assess and collect taxes against a partnership unless it takes steps to elect out of this new regime. That’s right: The partnership, and not its partners, will be required to pay the tax on any audit adjustment made to the partnership’s return!
So the partnership is now liable for taxes, how does that differ from now? If you’re not yet convinced why you should care about these rules, the following reasons may encourage you to reconsider:
- Unless the partnership proves otherwise, all taxes assessed at the partnership level under the new rules will be at the highest marginal tax rate applicable to its partners in that year. So, individuals will be assessed at their top rate of 39.6 percent, and corporations will be assessed at their top rate of 35 percent. Furthermore, tax-exempt partners will also be assessed unless the partnership takes steps to prove and avoid such an assessment.
- Perhaps even more convincing is that the assessment by the IRS for the year under audit will be reflected on the return for the year the adjustment is finalized (which could be years later), not the year under audit. So the partners in the partnership at the time of the final IRS settlement, and not the partners in the partnership for the year under audit, will bear the responsibility for payment of taxes, interest and penalties assessed as a result of the audit.
Now that we have your attention, let’s talk about options. Did you know that certain partnerships can “opt-out” of these new rules? In order to do so, they must fit the following requirements:
- Have 100 or fewer “qualifying” partners;
- Qualifying partners include: An individual, an S corporation, a C corporation, or an estate of a deceased partner.
- Affirmatively elect on each timely-filed tax return to opt-out;
- Disclose the names of all partners and their tax identification numbers; and
- Provide the partners with the opt-out notice.
If partnerships don’t opt-out, or don’t fit the opt-out requirements under these rules, they still have the opportunity to elect out of a partnership-level assessment. This election can be made at the time the partnership receives a notice of Final Partnership Administrative Adjustment from the IRS at the conclusion of the audit. If the partnership makes this election, then the partners in the partnership for the year under audit, and not the partners in the partnership for the year in which the audit is settled, will be responsible for paying any additional taxes, interest and penalties. However, there is a cost: the underpayment of tax interest rate used in this instance is increased by 2 percent over what it otherwise would have been.
Lastly, the current concept of a Tax Matters Partner (TMP) in partnership agreements is being replaced under these new rules. Instead, partnerships will designate a “partnership representative” to handle the audit and be solely responsible for all decisions associated therewith. Furthermore, this partnership representative no longer needs to be a partner in the partnership. So if the partnership doesn’t designate a representative under these new rules, the IRS is free to designate anyone it chooses!
There’s more to learn on these rules as well as additional guidance to come from the IRS, but it is time for you to begin considering their impact on both existing and new agreements of which you may be a part. Reach out to your tax and legal counsel to review your partnership/LLC agreements and address how you might handle these new audit rules. This will be especially crucial for any partners buying in to, or exiting out of, partnerships/LLCs after 2017.
Timothy A. Kalberg and Kimberly A. Woodside are tax shareholders and co-leaders of the real estate practice group at Perkins & Co., a Portland-based accounting firm with an office in Vancouver.