Is the IRS Targeting Partnerships?
In 2015, IRS audits of partnerships were up 18.6% over the previous tax year, according to the agency’s Fiscal Year 2015 Enforcement and Service Results. That is the highest audit rate partnerships have experienced since 2006. By comparison, in 2015, audits of large C corporations decreased by 8.8%.
The situation is expected to only get worse under the new rules for audits of partnerships that were enacted last November under the Bipartisan Budget Act of 2015. The new rules also apply to multimember limited liability companies (LLCs) that are treated as partnerships for federal tax purposes. (For simplicity, we’ll use the terms “partnership” and “partner” to refer to all entities and owners affected by the new partnership audit rules.)
Owners of these pass-through entities need to know the current partnership audit rules, which will remain relevant for a while longer, as well as the following:
Delayed Effective Date
The new partnership audit rules will generally apply to partnership tax years beginning after December 31, 2017. Affected partnerships may elect to apply the new rules to returns for partnership tax years beginning after November 2, 2015, and before January 1, 2018. But typically partnerships will be better off forgoing this election, since the new rules could make it easier for the IRS to audit them.
Current Rules for Partnership Audits
The current rules will continue to apply until the revised rules go into effect starting with tax years that begin in 2018. The IRS follows three regimes for auditing partnerships under the Tax Equity and Fiscal Responsibility Act (the law that was revised by the Bipartisan Budget Act).
New Partnership Audit Rules
The Bipartisan Budget Act of 2015 repeals the current unified partnership audit rules and the current electing large partnership audit rules. They’re replaced by a single streamlined set of rules that call for auditing partnerships and their partners at the partnership level.
Under the new streamlined guidance, any IRS-imposed adjustments to partnership items of income, gain, loss, deduction or credit for the applicable partnership tax year (and partners’ shares of such adjustments) are determined at the partnership level. Subject to the exceptions outlined below, any resulting additions to tax and any related penalties are generally determined, assessed and collected at the partnership level.
Under the new rules, the IRS will audit partnership items and partners’ distributive shares for the applicable partnership tax year (called the “reviewed year”). Any adjustments are taken into account by the partnership (not the individual partners) in the adjustment year.
Partnership Adjustment Options
Under the new audit rules, partnerships will have the option of demonstrating that an adjustment would be lower (more favorable to partners) if it were based on actual partner-level information for the reviewed year, rather than imputed amounts based solely on partnership information for the reviewed year.
As an alternative to taking an adjustment into account at the partnership level, the partnership can elect to issue adjusted Schedules K-1 for the reviewed year to its partners. In that case, the partners would take the adjustment into account on their individual returns in the adjustment year through a simplified amended return process. Schedule K-1 is the information return that must be provided to each partner. It shows the recipient partner’s share of all partnership tax items and includes other information needed to prepare that partner’s separate federal income tax return.
Finally, the partnership also has the option of initiating an adjustment for the reviewed year, such as when it believes an additional tax payment is due or a tax overpayment was made. The partnership would generally be allowed to take the adjustment into account either at the partnership level or by issuing adjusted Schedules K-1 to the partners.
As a result of the new rules, partners generally must treat each partnership item of income, gain, loss, deduction or credit in a manner that is consistent with the treatment of the item on the partnership return.
Exception for Small Partnerships
Similar to the provision in the current audit rules that exempts most small partnerships (with 10 or fewer partners) from the unified audit rules, the new rules allow eligible partnerships with 100 or fewer partners to elect out of the revised rules for any tax year. To be eligible for this election, all partners generally must be individuals, C corporations, foreign entities that would be treated as C corporations if they were domestic entities, S corporations or estates of deceased partners.
If the IRS audits a partnership that has elected out of the new rules, the partnership and its partners will be audited separately under the audit rules applicable to individual taxpayers.
Managing Audit Risks
Although the new partnership audit rules are complex, they’re expected to make it easier for the IRS to audit large partnerships. When they go into effect, businesses that are set-up as partnerships and multimember LLCs could be at a greater risk of being audited.
During the summer, the IRS is expected to issue additional guidance on the rules and we will keep you informed regarding any updates. In the interim, please contact us to discuss how these changes are likely to affect your business.