United States

Partnership audits: Major changes ahead

INSIGHT ARTICLE

Proposed rules scheduled to take effect Jan. 1, 2018, would significantly change the way Internal Revenue Service (IRS) auditors assess tax underpayments and penalties on partnerships. Here are key takeaways from RSM Senior Director Ashima Arora, presented at RSM’s 9th Annual Investment Industry Summit on Sept. 19, 2017:

  • Tax liability will be born by individuals who are partners during the year the adjustment is made, rather than the year in which underpayment occurred. Current partners could potentially be liable for taxes related to prior years, even if they weren’t partners at the time.
  • Individuals acquiring an interest in a partnership should be aware of possible understatements by the partnership in earlier years.
  • Imputed underpayment would be the net of all partnership adjustments multiplied by the highest individual rate or the corporate tax rate.
  • Partnerships must designate a partnership representative, who will have broad power to make decisions for the partnership during audits.
  • The rules are yet to be finalized. Still unresolved: opt-out provisions, procedures for administrative adjustment requests, determining amounts owed, and length of audits. 

Background

Before 1982, the IRS audited each partner separately. Inconsistencies in treatment led to the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), which evaluated both partnerships and individual partners.

TEFRA rules proved cumbersome and expensive. The Bipartisan Budget Act of 2015 created a new regime under which any tax, penalties and additions to tax are determined, assessed, and collected at the partnership level. Current partners could potentially be liable for taxes related to the years under audit, even if they weren’t partners at the time.

What to do now

  • Update offering memoranda to note that the partnership and current partners could potentially be liable for taxes related to prior years.
  • Revise partnership agreements to include procedures and terms for new partners and the exit of old partners; include indemnification provisions for taxes paid and set forth tax-sharing allocations among partners
  • Delineate duties and management responsibilities of the partnership representative

Liability opt-outs  

  • While the rules remain unfinalized, different mechanisms under consideration would permit a partnership to bypass or modify the liability allocation:
  • The “push out” option seems most favorable for hedge funds and private equity partnerships. It would let the partnership to shift liability to individuals who were partners during the year in which the liability was incurred.
  • The “elect out” option applies to partnerships with 100 or fewer partners; partners can only be S corporations, C corporations or estates. A hedge fund or private equity partnership with a general partner setup as a limited liability company (LLC) would be ineligible for this option, even if the fund had only individuals as partners.

Choosing the partnership representative

The new rules replace TEFRA’s tax matters partner with the new role of partnership representative. The partnership representative named on the original return audit can be changed only during the examination or by filing an administrative adjustment request, so choosing the right person is extremely important.

In choosing a partnership representative, consider:

  • Selection procedure
  • Duties
  • Limitations on power
  • Requirement for the partnership representative to notify partners in the event of an audit

Some organizations are marketing themselves as partnership representatives. Partnerships should consider carefully before designating an outside party to fill the role given the extensive responsibilities involved.

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