United States

Complexities of tax examinations for partnerships

Changes for tax year 2018

INSIGHT ARTICLE  | 

The IRS examination of partnerships is one of the most complex areas of tax procedure. And recently, it’s become even more complex with a new set of procedures in place beginning with tax year 2018. The new procedures were established as part of the Bipartisan Budget Act of 2015 (BBA), and replaced rules that had been in place since 1983, The Tax Equity and Fiscal Responsibility Act.

Partnership audits are procedurally complex because, although the partnership files a tax return on Form 1065, the income tax is paid by the partners based on income reported on the partner’s Schedule K-1. Consequently, examinations are done at the partnership level, but the liability for any additional tax due is at the partner level. Multi-tiered partnerships compound the complexity of determining liability for any additional tax.

Under the new BBA procedures, partnership examination takes place at the entity level, with the partnership represented by the partnership representative. Under the BBA procedures, the partnership representative has the sole authority to speak for the partnership in the examination, and can bind all partners with respect to the tax treatment of partnership-level items. The partnership representative does not have to be a partner—for example, the partnership representative could be a designated attorney who is involved in the partnership’s business operations.

Upon completion of a partnership audit, the IRS may propose adjustments that result in increased taxable income to the partnerships. Under prior law, if the tax matters and partners agreed to the partnership adjustments, it was then the responsibility of the IRS to flow the adjustment through each partner’s return and determine the additional tax due from each partner.

The BBA procedures significantly changed how partnership adjustments are handled. Once the IRS has proposed adjustments, the partnership has two options:

A.    The partnership can pay the tax due at the entity level. Under this option, the partnership would compute the tax due based on the net adjustments proposed by the IRS and then multiply the net adjustment by the highest applicable marginal tax rate.

B.    The partnership can “push out” the adjustments to the partners. In this option, the proposed adjustments are pushed out to the partners through tax statements for the tax year under examination. It is then the responsibility of each partner to file returns in the year of the adjustment reflecting the partner’s share of the proposed adjustment, utilizing any tax attributes such as net operating losses or credits, and then paying the tax due.

The partnership has 45 days from the date of the proposed adjustments to elect a method for dealing with the tax deficiency.

Based on these new procedures for partnership audits, the partnership faces some crucial decisions. First is the appointment of a partnership representative. Because the partnership representative exercises tremendous power to make decisions and bind the partnership, having a technically knowledgeable partnership representative is important. The other crucial decision is how to handle the IRS examination adjustments—whether to pay at the entity level or push out the adjustments to the individual partners.

Changes to partnership examination procedures reflect Congress’ intent to increase the number of partnership examinations. The rules will affect not only traditional partnerships such as law firms and physician practices, but also private equity firms and multitier partnerships. Planning now for an IRS exam will make the exam more efficient.

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