Starting in 2018, the IRS will have an easier time collecting underpaid taxes from the partnerships it audits, thanks to the new centralized audit regime (CAR). The new audit regime was passed in 2015 as part of the Bipartisan Budget Act of 2015, but wasn’t effective until Jan. 1, 2018.
The old rules, which came from the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), had no mechanism for tax collection. If the IRS determined that a partnership had understated its income, it was up to the agency to allocate the adjustment to the partners and to collect the additional tax due. With tiered partnerships, this could rapidly become complex. The IRS had to wade through the tiers until it reached a human, or a corporation, to collect from. The new law, which repeals TEFRA, makes it easier for the IRS to collect tax from partnerships.
No More Tax Matters Partner
First, the tax matters partner (TMP) was replaced with a partnership representative. This person will be the designated point person in dealings with the IRS. The partnership representative has broad powers to act on behalf of, and to make decisions for, the partnership. This person will have unlimited ability to agree to any audit adjustments made by the IRS. Decisions made by the partnership representative are binding, so it’s wise to choose this representative carefully.
The partnership representative does not need to be a partner in the partnership, and can be a separate entity, or even the partnership itself. All that’s required is a “substantial presence in the U.S.” If an entity is chosen, the partnership must designate a person who will represent the entity, or the IRS will appoint someone.
Because of the new broad powers and responsibilities for the partnership representative, it’s a good idea to amend partnership agreements to reflect this, and perhaps include indemnity for the partnership representative as part of that update.
Burden for Collecting Tax Shifts to the Partnership
The biggest change in the new audit regime is that any underpaid tax, plus interest and penalties, will be assessed and collected at the partnership level. Underpaid tax will be assessed by multiplying the net positive audit adjustment by the current highest individual or corporate rate. This means that the current partners will bear the burden of tax assessments from prior years, even if they were not partners at that time.
For example, let’s say the IRS decides to audit ABC Partners for Tax Year 2019. In 2021, the IRS completes its audit, and determines a positive audit adjustment. Under CAR, ABC Partners, itself, will be assessed additional tax, penalties and interest, none of which are deductible expenses. This may be unfair to the current partners, particularly if there has been a lot of turnover since 2019.
However, thanks to final regulations approved on Jan. 2, 2018, partnerships have two choices on audit. The partnership itself can pay the tax, or the partnership representative can elect to push it out as many levels as needed to get to a human or corporation. If the push out election is made, the additional tax will be paid by the partners of the partnership for the year of the adjustment.
This election must be made within 45 days of the date that the final notice of the partnership adjustment was mailed by the IRS. The partnership representative can make this election without consulting the partners. Once this election is made, the partners for the year of the audit will either pay their share of the assessed tax, or will need to file amended returns and pay the additional tax due.
Small Partnerships can Elect Out
Partnerships that have fewer than 100 “eligible partners” can elect out of the new audit regime. This is done on an annual basis on the partnership’s timely filed tax return. As defined in the IRS regulations, “eligible partners” can be individuals, C corporations, certain foreign entities, S corporations or estates of deceased partners. The IRS may revisit the definition of “eligible partner” after seeing how the new regime works.
If a partnership is audited and the election to opt out of the new regime was made, the IRS will have to make separate assessments at the partner level.
Advisors need to be aware of these changes and discuss the ramifications with their clients. Amending partnership agreements to cover these changes can be a headache – but it’s better than a lawsuit!