The 2018 Internal Revenue Service (“IRS”) partnership rules streamline the partnership audit process for the IRS, making it easier for the IRS to audit partnerships. The 2018 rules also create some planning opportunities for potential audits, as section 6223 of form 1065 now requires a partnership representative. In 2012, the IRS audited 27.1% of large C Corporations but only 0.8% of large partnerships. The streamlined rules for the 2018 tax year and beyond mean the IRS will likely audit partnerships more frequently. We encourage businesses taxed as partnerships to consider the changes discussed below and to take action as appropriate.
Bipartisan Budget Act of 2015: Effective January 1, 2018
The Bipartisan Budget Act of 2015 (the “BBA”) was enacted on November 2, 2015 and took effect on January 1, 2018. The BBA replaces the Tax Equity and Fiscal Responsibility Act (“TEFRA”). The BBA applies to all entities treated as partnerships for federal income tax purposes. This includes general partnerships, limited partnerships, limited liability partnerships, and many LLCs – since LLCs with multiple members by default are taxed as a partnership.
Under the BBA, the IRS will assess and collect partnership audit adjustments at the partnership level. Generally, these adjustments will affect the partnership, not individual partners, in the year the audit is completed. Significantly, this means the partnership could be responsible for tax deficiencies of former partners.
Partnership Representative Replaces the Tax Matters Partner
The BBA replaces the Tax Matters Partner with a Partnership Representative for participating partnerships. Under TEFRA, the Tax Matters Partner represented the partnership before the IRS in all tax matters including preparing and filing tax returns, providing tax information to partners or members, and managing audit processes or investigations. The Tax Matters Partner was required to be a partner or member of the business.
Similarly, the Partnership Representative will also conduct tax matters on behalf of the partnership and serves as the sole point of contact between the partnership and the IRS. However, under the BBA, the IRS does not have to notify the other partners or members in the partnership in the event of an audit – the IRS is only required to notify the Partnership Representative. Additionally, the Partnership Representative, with authority granted to it pursuant to federal statutory law, will have the sole authority to negotiate and resolve an audit with the IRS, which will bind all partners, members, and former partners or members.
The determination of who will serve as the Partnership Representative is different than how the Tax Matters Partner was determined under TEFRA. Under TEFRA, the partnership designated a partner or member as the Tax Matters Partner or the general partner with the largest profits interest in the partnership at the close of the taxable year served as the Tax Matters Partner. Under the BBA, the Partnership Representative has to be designated by the partnership, but the Partnership Representative does not have to be a partner or member of the business. The only requirement is that the Partnership Representative must have a substantial presence in the United States. Substantial presence means that the Partnership Representative must have a US taxpayer identification number, telephone number, and postal address, and must make themselves reasonably available to meet and communicate with the IRS. If an entity is chosen as the Partnership Representative then the entity must select a “designated individual” who would work with the IRS during a partnership audit.
Another significant change under the BBA is that if the partnership does not designate a Partnership Representative, the IRS may appoint one. Partnerships should consider the potential risks involved with an IRS-appointed Partnership Representative. It’s unclear exactly what considerations the IRS would consider when appointing a Partnership Representative (the partner with the largest interest in the partnership at the time of the audit? the partner with the largest interest in the partnership for the year in question? the partner who would have the largest tax payment?). Since the Partnership Representative has a great deal of control and power, the partnership could be at the mercy of that IRS-appointed Partnership Representative. Partnerships may want to designate someone to serve as the Partnership Representative to retain control over this decision.
Certain partnerships with 100 or fewer partners may elect out of the BBA tax audit requirements, instead opting to be audited under the general rules applicable to individual taxpayers. Electing out is available to partnerships with 100 or fewer partners if each partner is an individual, a C corporation, a foreign entity that would be a C corporation under U.S. law, an S corporation, or an estate of a deceased partner. For S corporation partners, each shareholder counts as one partner for purposes of the 100 partner limit. Businesses taxed as partnerships should evaluate the costs and benefits of electing out for their business.
The partnership must follow certain procedures to effectively elect out of the BBA tax audit procedure: the partnership must timely file an election to opt out for each tax year; the election must include the name and taxpayer identification number for each partner or member of the partnership; and the partnership must notify each partner or member of the election.
Points to Consider
When addressing this 2018 change, partnerships should consider whether it should opt out of the BBA tax audit procedures (if eligible). Absent opting out, some considerations include:
- How should the partnership determine who will serve as the Partnership Representative?
- When and how should the Partnership Representative be removed or replaced?
- Should the partnership agreement include provisions requiring the Partnership Representative to abide by a majority of the partners’ vote?
- Should the partnership require the Partnership Representative to contact partners about audits and other tax matters?
- In the case of an underpayment, should the partnership “push out” the underpayment?
- How should the partnership address the possibility of being liable for tax deficiencies of former partners?
- Should the partnership take steps to prevent assigning partnership interests to those that will foreclose the possibility of opting out?
Partnerships should be aware of these changes and monitor future guidance from the IRS. New partnerships should consider these changes when drafting their partnership agreements or operating agreements. If a partnership chooses not to opt out, partnerships should consider an appropriate person to serve as the Partnership Representative. If your partnership currently has a Tax Matters Partner, this individual may be well-suited to serve as the Partnership Representative in the new tax audit regime. However, the partnership should consider the additional responsibilities and powers involved with the Partnership Representative role, as well as the option to designate a non-partner individual.
About the Co-author: Peter Tran
Email: firstname.lastname@example.org | Direct: (503) 802-5551
Peter works to creatively find solutions to legal issues so clients can focus on maximizing their business opportunities. He is experienced with helping clients navigate their various business, employment, and tax challenges so that his clients can focus on their true passions.
About the Co-author: Heather Fossity
During her time with Immix, Heather worked tirelessly with several practice groups to help research projects and laws that would have real-life business applications for our clients. Heather was one of the elite candidates selected for the coveted Immix Intern/Extern program.