New audit rules apply to all entities treated as partnerships
TAX ALERT |
UPDATE: On Nov. 2, 2015, President Obama signed legislation that affects how the IRS audits partnerships (including LLCs) going forward.
Facing yet another debt ceiling crisis, the White House and Congressional leaders appear to have struck a tentative budget deal. On Oct. 26, proposed legislation was released that contains significant changes to partnership audit procedures and the methods used by partnerships to amend tax returns.
Although no timeline for voting or passage has been announced as of this writing, all signs point to a fast-track process that could result in enactment by week’s end, ahead of an expected breach of the debt ceiling on Nov. 3.
Changes to partnership audit procedures
This proposed legislation completely rewrites existing rules that govern the IRS’s ability to audit partnerships (including LLCs). The proposed changes include:
- A repeal of the vast majority of the existing partnership audit rules (also known as TEFRA).
- A requirement for partners to report positions consistent with the partnership return as filed, or to affirmatively notify the IRS of any inconsistencies.
- A requirement that any changes to items of income, gain, loss, deduction or credit as a result of IRS audit will be determined solely at the partnership (as opposed to partner) level.
- A requirement for partnerships to designate a partner (or other person) to have sole authority to act on behalf of the partnership and to bind the partnership on any decisions and determinations made as part of the audit or tax litigation process.
- Theoretical partnership liability for any resulting tax, effectively assuming that all partners are taxable at top rates. In practice, the partnership can avoid this liability and pass it on to the partners in a number of ways.
- In practice, audited partnerships will have the choice of passing the liability on to their partners by filing a revised Schedule K-1, which will make the partner responsible for paying the full, correct amount of tax, or paying a tax at the entity level, if that is simpler. A partnership will also be able to reduce any entity-level tax by demonstrating the tax status of their partners (e.g., exempt institutions, corporations, individuals eligible for capital gains rates) or by showing that their partners filed amended returns paying any added taxes that would have been due.
This new ‘adjusted’ K-1 procedure will be dramatically different from previous processes related to the allocation of audit adjustments or the issuance of amended K-1 forms. Unlike those prior methods, any resulting addition to tax will be imposed on the partner in the year in which the adjusted K-1 is issued. As a result, the partners in the audited partnership will not be required to file an amended return related to the audited year. Instead, the partner will calculate the tax that would have been owed as a result of any adjustments in that previous year and remit the tax with his current year return.
For some ‘small’ partnerships, the proposal allows the partnership to elect out of this new procedure and have all items determined at the partner level. This annual election can be made by partnerships that have 100 or fewer direct or indirect partners, none of whom are other than individuals, C corporations, S corporations (counting its shareholders among the maximum 100 partners/shareholders) or estates of deceased partners.
Changes to partnership amendment procedures
In addition to changes to adjustments initiated by the IRS, these new rules also impact changes initiated by partnerships themselves. The proposed legislation allows a partnership to rely on these new procedures to streamline or simplify the process of filing an amended return by:
- Allowing a partnership to elect to pay the taxes related to the amended return at the partnership level, thereby avoiding the process of allocating the adjustments to each impacted partner.
- Requiring partners who receive an amended K-1 to pay any tax due related to the changes on their current year tax return, in lieu of amending the prior year tax return to which the amendment or adjustment relates.
The changes included in this bill are generally effective for tax years beginning after Dec. 31, 2017. Although partnerships have over two years before ultimate imposition, if these proposals are enacted, partnerships will want to act quickly to review their current operations and structure for potential impact. It is likely that many entities may wish to revisit the current treatment of their ‘tax matters partner’ or other individual authorized to deal with the IRS, as these changes would dramatically expand that individual’s role. In addition, partnerships may wish to look to their liquidation procedures to ensure the capability to comply with these new rules in post-liquidation periods where statutes of limitation may still be open.
Technical corrections or regulatory guidance may be required
As a result of the way these provisions were added to the legislation, it is likely that some technical corrections will be required.
Some commentators have suggested that it was likely the intention of the drafters of this legislation to create a process of providing revised K-1s to the partners of an audited partnership, and imposing a corresponding tax liability on those partners, that would continue in situations where a partner is itself a partnership (a so-called upper-tier partnership). However, the bill as drafted may require the IRS to formally put the upper-tier partnership under audit to trigger such an obligation to pass-on its own adjusted K-1s. If the intent was to create a more ‘automatic’ approach (one in which each partnership that receives an adjusted K-1 is required to issue its own adjusted statements) some clarifications or technical corrections may be required.
It has also been suggested that more guidance may be required in regard to situations where an adjusted K-1 causes a partner overpayment, including the appropriate computation of interest that should be due to the taxpayer. Further, he suggested that provisions in the proposed legislation that impose a higher interest rates on partners for underpayments may be problematic, especially in cases where the ultimate liability is paid within a reasonable period of time.
The proposed legislation replaces what many have believed to be a flawed process
This proposed legislation is not unexpected, as many commentators and practitioners have long held the belief that the current statutory regime for auditing partnerships has failed to keep up with changes in the economy. Those who hold that opinion generally conclude that many investors who are required to pay taxes on their shares of partnership income are effectively immune to meaningful IRS review of the reporting positions taken on the underlying partnership returns.
Although little evidence exists to support any conclusion that this gap in the IRS’s review capacity translates in any way to any significant levels of noncompliance, it appears that the government has generally believed that a simplification of the rules would serve as a deterrent to potential future noncompliance. As a result, many legislative proposals have been put forward to fix these perceived issues.
Prior to this legislation, the most recent proposal was the Partnership Audit Simplification Act of 2015, put forth by House Ways and Means Committee member James B. Renacci. This bill, and many others like it, contained provisions that many in private industry considered problematic, if not unworkable.
A key concern of those in industry were provisions in that proposed legislation (and others like it) that would have fundamentally changed the nature of partnership taxation by imposing taxes directly upon partnership under audit, in all cases. Further, these proposals held that the ultimately liability for payment of such taxes would not be limited to the partnership, but the partners themselves would also be jointly and severally liable.
Partially due to political pressure related to those concerns, the Partnership Audit Simplification Act was not enacted. Although that bill had not passed, many held concerns that it could be ‘pulled off of the shelf’ and added to a larger package of tax provisions (a scenario that nearly occurred during the most recent extension of the Highway Trust Fund.)
Recognizing the political momentum behind a revision to the current partnership audit program, a number of commentators publicly suggested modifications to the Partnership Audit Simplification Act that would preserve the ability of the IRS to improve its audit process, while also allaying industry concerns. It appears that many of these taxpayer-friendly changes have made their way into this proposed legislation, including:
- The ability of a partnership to elect out of entity-level taxation through issuance of adjusted statements to partners
- The ability of a partner to report and remit tax related in the current year, in lieu of filing an amended prior year return
- The ability to adjust the partnership level tax rate to account for lower tax rates applicable to tax-exempt investors, C corporations, qualified dividends and long-term capital gains
- The removal of joint and several liability on individual partners for partnership tax debts