Partnerships Are Now Liable for U.S. Federal Income Tax
The Bipartisan Budget Act of 2015 established new rules for partnership audits and the assessment of tax. Effective for partnership returns filed for tax years beginning after December 31, 2017, the new partnership audit regime changes the way partnership adjustments are determined, and for the first time, makes a partnership liable for U.S. federal income tax.
Prior to 1982, IRS partnership audits assessed and collected tax at the partner level. The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) was enacted to streamline examinations of partnerships by requiring that issues be handled in a single, unified partnership-level proceeding instead of multiple proceedings at the partner-level. Partner-level adjustments, assessment and collection still occurred on a partner-by-partner basis, however. Partnerships with less than ten partners were not subject to TEFRA and any partner had the ability to challenge the IRS on an examination.
New audit regime
As of 1/1/2018, TEFRA is repealed and a new centralized partnership audit regime under the Bipartisan Budget Act of 2015 (BBA) is in effect. Partnerships that cannot or do not elect out of BBA are, by default, liable in the adjustment year for any imputed underpayment amount (IUA) calculated by multiplying the total netted partnership audit adjustment by the highest income tax rate — this burden then falling on the current year partners. Allocation of the IUA amount can be determined under the partnership agreement, subject to rules that advise how the allocation must be made to be approved by the IRS. The partnership may modify the underpayment amount if they can show the IRS that a partner’s share of an adjusted item is subject to a lower tax rate, or if they can establish that a partner has agreed to an adjustment and paid the resulting tax through an amended return.
There is an alternative procedure to amending returns because of an IUA, known as a pull-in modification. A pull-in modification allows the partners for the reviewed year to pay the tax based on the audit adjustments without having to file an amended return.
Alternative “push-out” election
Another alternative is the “push-out” election, which transfers the IUA out of the partnership to the partners in the reviewed year. The election must be made within 45 days of the date the final partnership adjustment is mailed by the IRS and is revocable with IRS consent. Each reviewed year partner calculates their tax for the reviewed year and any interim years after the reviewed year and preceding the adjustment year. The partners then pay the aggregate tax plus interest (an additional 2% interest is charged using this election) and penalties with their income tax return for the adjustment year (i.e. the current year’s tax return). Adjustments may be pushed through to ultimate taxpaying partners in tiered arrangements.
Electing out of BBA
A partnership that is required to furnish 100 or fewer Schedule K-1s during the tax year can elect out of BBA. Any K-1’s that go to S-Corporations must include the number of K-1’s that S-Corporation issues on their pass-through entity tax return in determining the 100 or fewer requirement. In addition, all partners must be eligible partners. Eligible partners include only individuals, C corporations, S corporations or estates of deceased partners. The list of eligible partners does not include partnerships, disregarded entities or trusts. If there is even one ineligible partner, the partnership cannot elect out of BBA. The election must be made annually on a timely filed return, and the partnership must notify partners of the election within 30 days of making the election. The result of this election moves the adjustment and assessment of tax to the partner level.
Designating a Partnership Representative
Under BBA, the Tax Matters Partner (TMP) is eliminated and replaced with a Partnership Representative (PR). Each taxable year, the partnership must designate a partner or other person with substantial U.S. presence as the PR. If the partnership does not designate a PR, the IRS can select any person. The PR has sole authority to act on behalf of the partnership for purposes of the audit and all partners are bound by the representative’s actions.
With these significant changes now being implemented for the 2018 tax year, some of the items to address now include:
- Appointing a partnership representative
- Determining whether the partnership qualifies to opt out of BBA and if so, whether to opt out for the current tax year
- Updating the operating agreement for partnerships unable to opt-out to include
- How the partnership will pay an imputed underpayment
- How the underpayment will be allocated amongst the partners
- Whether or not the partnership will push-out the payments
- The manner in which the payment will be funded
- Addressing how audit adjustments will be handled between old and new partners
Any changes to the operating agreement must be made by the due date of the 2018 return (not including extensions).
Here at Delap LLP, we are committed to bringing you the highest level of service and making sure that we are aware of policy developments that affect our clients. If you have any questions on how the new partnership audit regime could affect you or your business, please contact our team today.
Delap LLP is one of Portland’s largest local tax, assurance, wealth advisory, and information security consulting firms, located in Lake Oswego, Oregon.
Partnership Audit Updates from Delap
December 13, 2018, Delap’s Joe Siefert presented on Partnerships and the changes that may require updated operating agreements.
This presentation should get you up-to-speed on the significant changes Congress enacted to the partnership audit and adjustment rules. This new regime changes how tax adjustments resulting from partnership audits are assessed and collected. As a result, partners will need to carefully review and likely revise their partnership’s operating agreement.
- A summary of the major changes to the partnership audit procedures
- Various elections covered by these new audit procedures
- Challenges these procedures present to partnerships
- The roles and responsibilities of the partnership representative
- Suggested items to address or modify in partnership operating agreements
We will be providing a webinar to explain the changes and what options may be available to your partnership: