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Partnership Audits –Be Careful what You Wish For?

CrossroadsFor years, everyone involved with audits of partnership tax returns (tax professionals, the IRS and the taxpayers themselves) have complained about the often complicated and unclear Tax Equity and Fiscal Responsibility Act (TEFRA) rules. Disputes between the IRS and partnerships, as well as between the various partners, often dragged on for years. 

That is  if the IRS even bothered to start an audit – audit rates for partnerships were historically low compared to similar size corporate entities. Once an audit finally was completed, the IRS would face the onerous task of tracking down and collecting the assessments from each partner, often having to dive through dozens of tiers to find these ultimate taxpayers. Naturally, this resulted in difficulty collecting the additional tax, making the whole exercise seem futile to some. A better way was needed. TEFRA had to die.

There’s an old saying – “be careful what you wish for.” As part of the Bipartisan Budget Act of 2015, an entirely new partnership audit regime was established, effective with returns filed for tax year 2018 and later. TEFRA is dead, although it will be a slow and probably painful death. The best guess is that the last TEFRA audits won’t be resolved until 2022 or later.

So why do I say that? While the new regime is an improvement, it also contains a lot of subtleties, along with complicated and often confusing rules that I explain in a short video. Certain small partnerships will be able to opt out. The IRS will then presumably need to audit each partner, although this is still unclear. To be eligible for this opt-out, a partnership may not issue more than 100 K-1s for the selected tax year and may only have partners who are individuals, corporations and the estates of deceased partners. In counting the number of K-1s, each owner of an S corporation is counted as an additional one.

How Will it Work?

Under the regime’s basic framework, the IRS will notify the partnership and the Partnership Representative (but not the partners themselves) that a return has been selected for audit. The Partnership Representative replaces TEFRA’s tax matter partners, but has much more authority and responsibility. The representative is the only point of contact between the IRS and a partnership during an audit.

Below are some other key terms related to the new process:

  • Reviewed year: The tax year being audited.
  • Adjustment year: The year the assessment resulting from an audit is made final, either through a Notice of Final Partnership Adjustment (FPA) or court decision.
  • Imputed underpayment: The amount of additional tax assessed, calculated by netting the audit adjustments multiplied by the highest tax rate in effect during the reviewed year (currently 39.6%), subject to certain modifications.

The Partnership Representative will have full authority to negotiate and resolve the audit with the IRS. Upon completion of the audit and issuance of the FPA, the partnership itself will pay the imputed underpayment. The ultimate financial responsibility for the assessment payment falls on the adjustment year partners, who may not necessarily be the same as the reviewed year partners.

Picture Still Muddy on Tiered Partnership Impact

The Partnership Representative can make elections or modifications to achieve what one IRS official has called “rough justice.”  These permitted adjustments reflect an attempt to better align the amount of additional tax due, as well as the ultimate financial responsibility, with what the result would have been had the partnership reported the adjusted items correctly on the original return.

While still requiring the partnership to pay the assessment directly, the amount of the imputed underpayment can be reduced through several modifications, subject to approval by the IRS. 

Alternatively, the Partnership Representative may select what is called the push-out option. Under this option, the partnership will issue “adjustment K-1s” to each reviewed year partner, reflecting their allocable share of the adjustments. The additional tax, interest, and penalties would be reported and paid by the partner on their tax return for the adjustment year.

Good bad uglyPerhaps the most critical unanswered question at this time is how the modifications allowed under the basic framework or use of the push-out option will work in the context of tiered partnerships. Public statements by several IRS representatives have raised concerns that the proposed regulations will interpret the law in a taxpayer adverse manner. The indications have been that the IRS will allow a partnership to request modifications or push out the adjustments up to one tier only, to its direct partners, rather than to multiple tiers, which would reach the ultimate indirect taxable partners. For a more detailed discussion of what we know about the regime at this time, along with other potential areas of concern, see the July 2016 issue of The Tax Adviser.

As the IRS and Treasury work to develop guidance implementing these new rules, the AICPA Tax Advocacy and Policy team will continue to advocate for the taxpayer- and practitioner-friendly answers to the many other open questions. Our Partnership Tax Technical Resource Panel met with government officials to discuss these issues in June and will do so again in November.   Meanwhile, the AICPA anticipates submitting detailed recommendations to the IRS and Treasury regarding the new partnership audit rules in the next several weeks. Finally, the AICPA will be working with CPA state societies as the states consider the impact of new rules for partnership audits on their own procedures.

Jonathan Horn, CPA, CGMA, Senior Technical Manager, Tax Policy and Advocacy, American Institute of CPAs. 

Crossroads and dice courtesy of Shutterstock.

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