New Partnership Audit Rules: Why Your Operating Agreement May Need a Tune-Up

By Chelsea O'ShieldsFollowing the implementation of the Bipartisan Budget Act of 2015, there is a big change coming that could be overlooked with all the other tax law changes. Partnerships and the partners will notice a change in IRS audit procedures for tax years 2018 and beyond.

New Rules and Effective Date

Prior to 2018, the IRS conducted audits in accordance with the Tax Equity and Fiscal Responsibility Act (TEFRA), which assessed adjustments of partnership items at the partner level. This caused some grief for the IRS due to several inefficiencies - locating and interacting with each partner, collection from individual partners, and tiered partnership complexities.To combat these issues, the IRS created the new Centralized Partnership Audit Regime (CPAR), with the hope of simplifying adjustments, limiting the number of individuals with decision making authority, and accelerating collections. Under the CPAR, the IRS will now, by default, assess and collect any understatement of tax, interest, and penalties at the partnership level. This is an unfavorable option for most business owners, as the new rules take the highest rate between the individual rate and the corporate rates. Also, the imputed underpayment amount is now assessed in the Adjustment Year (year adjustments are final) and NOT the Reviewed Year (the tax year under examination).

What Role Does the Partnership Representative Have and Who Can be Designated?

Another key element of CPAR is that all taxpayer responsibility - including settlement authority - is placed in the hands of one person. Previously, under TEFRA, a Tax Matters Partner would simply be the "middle-man" between the partnership and the IRS. Under CPAR changes, the Partnership Representative (PR) has full authority and is not bound by fiduciary duty to act in the best interest of the company. The PR must be designated on each year's tax return. Another related change for 2018 tax year and beyond, is that the PR is no longer required to be a partner in the partnership - it can be anyone that the partnership feels is competent enough to make decisions on IRS assessments. If no PR is appointed, the IRS will appoint one. The PR can be removed, but only after a Notice of Administration Proceeding is issued by the IRS.

Should the Partnership Elect Out of the New Partnership Audit Rules?

The IRS has provided an option to elect out of these new changes, as well as to elect to have the new rules apply earlier (2015-2017 tax years). To completely elect out of these changes, the partnership will have to meet two requirements: 1) the partnership must have 100 or fewer partners during the year and 2) all partners must be "eligible partners" at all times during the tax year. This election must be made on an annual basis. Upon electing out, the partnership and partners are audited, assessed, and taxes are paid and collected under Pre-TEFRA deficiency procedures.

Should the Partnership “Push-Out” Following an Audit?

The partnership can also elect to "push out" the tax liability to the reviewed-year partners. Unlike the election to elect out, this option is available to all partnerships, but this option is made at the sole discretion of the Partnership Representative. The partnership must make this election within 45 days after the IRS issues the final adjustment. The partnership must also issue a revised statement K-1 to the partners and the IRS with this election, which shows each partner's share of the adjustment. While the partners will increase the tax on their return for the year of the statement, the tax rate used is that of the reviewed year.

Should the Partnership Take Action to Amend the Operating Agreement?

If a partnership is not eligible to elect out of the new partnership audit rules, the partners should take action now to amend the partnership operating agreement. The amended agreement should specifically denote the PR (partnership representative), his/her responsibilities, possibly indemnify partners from the economic impact of a potential assessment based on a review year when they were not partners, and consider electing special rules for partner-level assessment. Even in the case that the option to elect out is made, partners should still consider revising operating agreements, since this is something that will need to be addressed each year. These provisions could include the decision to automatically elect out of the new rules upon signing of the agreement, putting a procedure in place where the partners, by majority vote, can authorize the partnership representative to make the election, and including language that dictates when the Partnership Representative will be liable to the partners for failure to make an election or making an election that was not in the best interests of the partnership. These considerations would be best discussed with your trusted CPA and legal counsel.