When Congress took up the task of adopting a federal budget, nobody expected the effect it would have on partnership taxation.  In fact, though, in passing the Bipartisan Budget Act of 2015 (the Budget Act), which President Obama signed into law on November 2, 2015, two provisions were included affecting partnerships and their partners, as follows –

• New rules for partnership audits and the resulting adjustments, and
• Amendments to certain code sections relating to the determination of who is a partner.

Prior to the changes that I am about to discuss, audits of partnership tax returns have been governed for the last 34 years by a 1982 law called the Tax Equity and Fiscal Responsibility Act (TEFRA).  Under TEFRA, Partnerships were subject to unified audit rules and included special rules for “electing large partnerships”. 

Under those rules, unless an eligible partnership affirmatively elected otherwise, any audit adjustments proposed by the IRS until now have been assessed against the individual partners, rather than against the partnership.  As a result, this regime has carried with it a potential administrative burden for the IRS in having to potentially assert assessments against tens, hundreds or even thousands of partners in a partnership, rather than only assessing against the partnership, itself.   This discussion will center on the new rules for partnership audits.

What’s changed?

With the passage of the Budget Act, audits of, as well as assessment and collection of underpaid tax will be handled at the partnership level, rather than against individual partners, as under prior law.  Therefore, partnerships may now find themselves subject to an entity level tax, which flies in the face of the concept of a partnership as a pass-through entity.  More on this later.

Which partnerships are subject to the new guidelines?

The short answer is that all partnerships are subject to the new regime.  There is, however, an opportunity for certain qualifying partnerships to elect out of the new regime on a year-by-year basis.  What partnerships qualify?

• Partnerships that are required to furnish 100 or fewer statements under section 6031(b) (schedules K-1, for example) with respect to its partners; and
• Each of the partners in the partnership is an individual, a decedent’s estate, a C corporation, an S corporation, or a foreign entity that would be treated as a C corporation if it were domestic, and

There are special rules that apply to partnerships with S corporation partners that will probably make the election process unattractive for them.  In addition, partnerships with other partnerships or trusts as partners are ineligible to elect out. 

In addition, the process to elect out can be quite cumbersome, bordering on onerous.  To do so, the partnership must make the election on its timely-filed return, and must disclose the name and taxpayer identification number (TIN) of each partner.  The partnership will also be required to notify each partner that the election was made.

How will the new rules be applied?

Generally, the IRS will conduct audits at the partnership level, examining items of income, gain, loss, deduction or credit of the partnership.  If there are amounts to be assessed, rather than adjusting each partner’s income tax return for the various items they find, and separately calculating the tax effect on a partner-by-partner basis, the IRS will assess and collect any taxes, interest or penalties resulting from their adjustments from the partnership.  The partnership will not have to issue amended K-1s to the partners for changes to the tax year being adjusted, but, since the partnership will be paying the assessed amounts in the year of the audit, it is possible that partners who were not in the partnership in the adjustment year will have to bear a share of the cost of such adjustments.  Under this regime, the IRS is likely to generate more tax revenue than they would previously, because the taxes assessed to the partnership will be determined at the highest individual or corporate tax rate for that year (currently 39.6%).

There is a mechanism in place where a partnership can pass the assessment along to those who were partners in the adjustment year, but the process is cumbersome and interest will be paid at a higher rate than if the assessment had been paid by the partnership.

When are the new rules effective?

The new partnership audit rules are effective for all partnerships for the first tax year beginning after 2017.  The delay in implementation is most likely in place to allow the IRS to develop and issue guidance for implementation of the new rules.  In addition, with a presidential election looming between now and the date of implementation, the makeup of congress, as well as the identity of the next president can play a very large part of how much, if any, of these rules eventually come to pass. 

As more guidance is developed and we all see how the political winds shift, we will begin to get a sense of what the partnership audit rules will actually look like when they are implemented.  Stay tuned.

Tax law can be confusing and the staff of the Zinner Tax Services department are ready to help. Contact me at hkass@zinnerco.com or any of our professionals at 216-831-0733.