What Businesses Taxed as Partnerships Need to Know About the New Centralized Partnership Audit Rules
For tax years beginning after December 31, 2017, a new centralized partnership IRS audit regime will generally apply to businesses taxed as partnerships for federal income tax purposes. These businesses include general partnerships, limited partnerships, limited liability partnerships, and many limited liability companies. Businesses taxed as partnerships should consider amending their applicable partnership agreements or limited liability company operating agreements to address these new rules and avoid unintended consequences in the event of an IRS audit, including potentially significant and distorted tax consequences for owners.
Background
The new centralized partnership audit regime was required by Section 1101 of the Bipartisan Budget Act of 2015. To implement the centralized partnership audit regime, the Internal Revenue Service published 277 pages of proposed implementing regulations.[1]
Under the current partnership audit regime, IRS partnership audits are normally conducted at the partnership level. Partners, however, have broad information and participation rights in the audits, and all adjustments are paid and enforced at the partner level. In a significant departure from the current regime, the general rule under the new regulations is that an imputed underpayment will be assessed and collected at the partnership level (subject to a potential push out election) rather than at the partner level. The new centralized partnership audit regime is expected to increase the number of partnership audits, make it easier for the IRS to collect deficiencies, and generate an estimated additional $9.325 billion of federal revenue by 2025.
The ability of the IRS to assess and collect imputed underpayments at the partnership level could create distorted tax consequences. For example, consider a scenario where, in the year 2020, a limited liability company that is taxed as a partnership is audited for tax-year 2018 and that, as a result of the audit, the IRS assesses and collects an imputed underpayment for tax-year 2018 from the limited liability company in the year 2021. Assume that member A was a limited liability company member during 2018 and 2019, but sold its interest to member D in 2020. This common scenario where an interest in a business that is taxed as a partnership is transferred to a new owner has the potential to distort tax consequences by, in this example, effectively shifting member A’s portion of the tax-year 2018 imputed underpayment to member D, who was not even a member of the limited liability company in 2018.
In addition, under the new regulations, a partnership representative, instead of a specific tax matters partner, will be appointed. The partnership representative, which need not be a partner, will have much broader authority than the tax matters partner. The partnership representative will have the sole authority to act on behalf of and bind an audited partnership and its partners, and no other partner will be able to participate in the audit proceedings. This authority includes consenting to an imputed underpayment and extending the statute of limitations. In addition, unlike the tax matters partner, the partnership representative will have no duty to notify partners of a partnership audit or significant audit developments. Because of this, many businesses that are taxed as partnerships may desire to contractually require the partnership representative to receive permission to, among other things, settle or compromise a partnership audit and to keep the partners reasonably informed regarding the status of any partnership audit.
Opting Out of the New Centralized Partnership Audit Regime
Businesses taxed as partnerships with 100 or fewer eligible partners may, on an annual basis, elect out of the application of the new centralized partnership audit regime on a timely filed return. Ineligible partners for the opt-out rule are expansively defined and businesses taxed as partnerships with even one partner that is a trust (including a grantor trust that is frequently used for estate planning purposes), disregarded entity, or other partnership will be ineligible to elect out of the new centralized partnership audit regime. For businesses taxed as partnerships that elect out, the IRS will be required to open deficiency proceedings at the partner level, instead of at the partnership level, to adjust items associated with the partnership, resolve issues, and assess and collect any tax that may result from the adjustments.
Even though the preamble to the proposed implementing regulations states that “the IRS intends to increase the number of partnership audits for both partnerships that are subject to the centralized partnership audit regime and partnerships that have elected out of the partnership audit regime” and that “the IRS intends to carefully review a partnership’s decision to elect out of the centralized partnership audit regime,”[2] we anticipate that many businesses taxed as partnerships that have 100 or fewer eligible partners will desire to elect out of the new centralized partnership audit regime. Businesses taxed as a partnerships that desire to elect out the new centralized partnership audit regime should consider contractually preventing the transfer of any ownership interest in the business to ineligible partners.
Preparing for the New Centralized Partnership Audit Regime
Businesses that are taxed as partnerships, including general partnerships, limited partnerships, limited liability partnerships, and many limited liability companies, will find it necessary or desirable to amend their partnership or limited liability company agreements to address the new centralized partnership audit regime. At a minimum, the familiar tax matters partner provisions should be amended to address the new partnership representative concept. Businesses taxed as partnerships should carefully choose their partnership representative and assure that their agreements provide appropriate guidance for the exercise of the partnership representative’s broad authority and require the partnership representative to keep the partners, or at the very least the business’ management or board, reasonably informed of the status of any partnership audit. To avoid potential disproportionate tax consequences, we also generally recommend that provisions concerning the indemnification of the partnership and the partners be considered to account for the characteristics of different partners and tax adjustments under this new regime that could otherwise disproportionately affect certain partners.
The new centralized partnership audit regime has significant implications for businesses that are taxed as partnerships which should be addressed. Please contact one of the authors or your regular Koley Jessen contact with any questions.
[1] REG-136118-15 is available at https://www.irs.gov/pub/irs-drop/reg-136118-15.pdf.
[2] Id. At 44.