IRS Announces New Centralized Audit RegimeAugust 08, 2018
A new “centralized partnership audit regime” is now in effect for partnerships, including limited liability companies (LLCs) that are treated as partnerships for tax purposes. The new regime, which was enacted by the Bipartisan Budget Act of 2015, applies to all partnerships for taxable years beginning on or after January 1, 2018.
The changes are expected to dramatically increase the audit rates for partnerships and will require partners to carefully review, and most likely revise, their partnership’s operating agreement.
Important new provisions to be aware of:
- The IRS can now collect any additional assessment of tax, interest, and penalties directly from the partnership rather than from the partners.
The tax is calculated using the highest individual tax rate (subject to a complex and cumbersome modification process), regardless of the character of the income. This means that adjustments to income coming from partnership audits could ultimately result in more aggregate tax being paid than if the partnership had properly reported its income to its partners in the first place. The Joint Committee on Taxation expects this new audit process to generate approximately $9.3 billion in additional revenue from 2016 – 2025.
- Current partners could be responsible for the tax liabilities of prior partners.
- Certain partnerships with 100 or fewer partners can elect out of the provisions. Each partner must be an individual, a C corporation, any foreign entity that would be treated as a C corporation if it were domestic, an S corporation, or an estate of a deceased partner. The partnership may elect out of the default regime by filing an annual election with the timely filed tax return and providing information about their partners. However, the partnership can’t elect out if it has a partner that is another partnership, a disregarded entity or a trust (including grantor trusts).
- A partnership representative (“PR”) replaces the prior tax matters partner (“TMP”).
By statute, the partnership representative is the only person empowered to work with the IRS and will have full authority to bind the partnership and the partners during an audit. A partnership and all partners are bound by actions taken by the partnership and any final decision with respect to the partnership.Also, the need to designate a PR in lieu of a TMP is significant since if a PR is not designated then the IRS has the authority to make the designation itself. The PR does NOT need to be a partner of the partnership, but they must have a “substantial US presence”.
- If a partnership receives an assessment notice, it can elect the alternative payment process (a push-out election) within 45 days. Partners will pay interest on any underpayment at a rate that is 2% higher than the normal interest rate. The 45 days may be troublesome in a tiered partnership structure.
Partnerships should decide whether to amend their partnership agreements to include provisions regarding whether to require, prohibit or permit the partnership to make the push‐out election in the event of an imputed underpayment.
When deciding whether and how to update partnership agreements, some of the many considerations partnerships might wish to consider include:
- Whether to prioritize certainty or flexibility. Will certainty regarding the treatment of all adjustments help or hinder a partnership’s efforts to attract new partners? Does the partnership want the flexibility to consider each adjustment individually?
- Whether to wait for additional guidance regarding how additional aspects of the election will function. For example, there is no guidance at this juncture regarding whether capital account and outside basis adjustments must be made in the reviewed year or the adjustment year. Depending on the situation, either result could have a distortive effect.
- Whether to accept the additional complexity and administrative burdens, which grow with every additional partner, which the push‐out election creates.
- How to deal with the potential admission of ineligible partners, and whether that should occur.
- Whether to require consent of the majority of the partners before the PR can waive the statute of limitations, settle with the IRS, or make a “push-out” election to move the payment obligation from the partnership to partners.
- Whether to impose a mechanism to collect from the partners if the PR settles with the IRS and the partnership pays an IRS assessment.
- The agreement can also name the partnership itself as the PR and then later identify the specific person to represent the partnership.
- Address the funding of payments of tax at the partnership level.
- Requirement to maintain contact information for former partners.
- Address any indemnities for the PR and buying/selling partners.
It is advisable to amend the partnership agreement sooner rather than later to avoid disputes that may arise in the context of an audit, or amended return, and to designate a partnership representative.
We would strongly recommend that partnerships amend their partnership agreements prior to any transfer of interests, admissions of new partners or withdrawals of existing partners.
The IRS recently finalized (and published) proposed regulations on the procedures for designating a partnership representative and the authority of the partnership representative under the centralized partnership audit regime. Our office can help you understand the new rules in order to determine whether these changes would be beneficial to your situation and also help explore other planning opportunities as necessary.