Section 1101 of the Bipartisan Budget Act of 2015 changed the rules relating to the federal tax audit of partnerships. The new rules are effective for tax years beginning after December 31, 2017. For purposes of the law, it also applies to LLC’s taxed as partnerships for federal income tax purposes.
The new rules replace the “tax matters partner” with the “partnership representative”, who has much more power and is the sole person with authority to talk with the Internal Revenue Service on behalf of the entity.
As many of you know, an entity taxed as a partnership is a flow-thru entity, which means the partners and not the partnership pay the tax. So, when there was an audit of a partnership tax return (form 1065), each partner’s return would need to be revised as well and the partner could potentially owe additional tax, as opposed to the partnership.
Now, the process has changed. If a partnership tax return is audited and if it is determined that the partnership tax return should be adjusted, then the tax, interest, and penalties will be assessed against the partnership and the tax rate assumed is the highest marginal income tax rate. There will no longer be a need to then audit each individual partner’s tax return.
Moreover, if a partnership tax return is audited, any adjustments apply in the years of the audit and not the year being audited; thus, if the partners are not the same, then the partners in the year of audit could be subject to such expense even though they were not partners for the year being audited.
All partners are bound by any determination made at the partnership level and there are no partner level defenses to penalties. Thus, the decision about who will serve as partnership representative should be carefully considered.
This new rule applies to all partnerships unless the partnership opts out of such treatment; however, there are requirements before a partnership can elect to opt out, which can be tedious. If you elect to opt out of the new law, then you should discuss that option with your CPA.
The new rules apply to all partnerships and LLC’s taxed as partnerships beginning in 2018, unless the entity elects to opt out of the new law. It is strongly recommended that you amend your partnership agreement/company agreement to comply with the new law.
If the election is made by the partnership to opt out of the new law, then the IRS will conduct any audit under the old rules and the tax will not need to be paid at the partnership level. Instead, the individual partner for the applicable tax year will be responsible for the tax.
However, the election needs to be made annually. But, to opt out of the new law, then for the applicable tax year, (1) the partnership also has to opt out of the new law, (2) each partner must be an individual, a C corporation, an S corporation, or an estate of a deceased partner, (3) the partnership has to have 100 or less partners, and (4) the partnership notifies each partner of election.
So, if a partnership has another partnership as a partner or a trust as a partner, then the partnership will not be permitted to opt out of the new law.
The foregoing is merely an overview of the new law. When it is time to file your tax return, you will need to discuss filing requirements with your CPA. Further, how a partnership can reduce its tax liability if it is audited is beyond the scope of this article.
Moreover, if you have a partnership or LLC taxed as a partnership, your partnership agreement/ operating agreement should be amended to comply with the new law, even if you anticipate opting out of the current law.
The fee for the amendment is $385.00. Please contact us if you would like us to prepare such amendments to comply with the law.