Changes to IRS income tax audits are on the horizon

January 17, 2018|Shane Wheeler

A change to partnership income tax audits is effective for tax years beginning after December 31, 2017, and there are important items to consider when drafting partnership agreements. 

For those of you who own an interest in a partnership, an important change is coming for partnership income tax audits. Effective prospectively for partnerships with tax years beginning after Dec. 31, 2017, a new streamlined set of rules for auditing partnerships will take the place of the old partnership audit procedures.

Prior to the change, adjustments resulting from the audit of a partnership would be pushed out to the partners’ individual returns. The new streamlined rules effectively create an entity tax, whereby any tax liability resulting from partnership audit adjustments will be paid at the entity level. Partnerships will be required to pay tax equal to the “imputed underpayment,” which will generally be the net of all adjustments multiplied by the highest corporate or individual tax rate. There are a few exceptions, but this will become the general rule.

Which partnerships will be impacted by the change?

These new rules will apply to all partnerships, including limited liability companies taxed as partnerships, regardless of size. However, the rules provide for an election to opt out of the new rules for partnerships with 100 or fewer qualifying partners. A qualifying partner is any partner that is an individual, a deceased partner’s estate, a corporation, a foreign entity that would be required to be a C corporation if it were domestic, and/or an S corporation. A qualifying partner does not include a partnership or a trust.

It appears that single-member LLC partners and even grantor trusts will not be considered a qualified partner and thus will result in the partnership not being able to opt out of the new rules.

Special attention should be paid when a partner is an S corporation, as all of the shareholders of the S corporation will be counted when determining whether the partnership meets the 100 or fewer qualifying partners threshold.

Should you opt out of the new rules?

These rules are expected to make it easier for the IRS to perform partnership audits, so it follows that partnerships that cannot or do not opt out may be at a greater risk of being audited.

Our recommendation is that eligible partnerships should consider making the election to opt out of the new rules. The election to opt out may be a deterrence to the IRS to audit the partnership.

The opt-out election is made as an annual election with your partnership tax return. Also, if a partnership does not, or cannot, opt out of the new rules, any audit adjustments can result in the current partners bearing the tax of the partners from the year under IRS audit. There are two options that a partnership can deploy to push the tax to the correct partners. Although the mechanics of the two options are different, the end result is that the partners from the reviewed year will pay tax on their share of adjustments, rather than the tax being borne by the current partners.

Elimination of the Tax Matters Partner

These new rules also eliminate the term “Tax Matters Partner,” a term commonly found in partnership agreements. The IRS is now requiring the partnership to designate a “Partnership Representative” who will have sole authority to act on behalf of the partnership under the new rules. If the partnership fails to designate a “Partnership Representative,” the IRS has free rein to select any “person” to serve as the “Partnership Representative.” If a partnership is not opting out, this will need to be addressed in the partnership agreement.

Items to consider in partnership agreements

As a result of these new rule changes most existing partnerships, as well as newly formed partnerships, will need to consider several things when preparing or reviewing their partnership agreements. Many, if not all, partnerships will need to amend their partnership agreements to address the following considerations. Those considerations include, but are not limited to, the following:

  • Who should be the partnership representative?
  • Should the partnership opt out of the new rules if available?
  • Should the partnership elect in for the 2016 fiscal year-end (not yet filed) or 2017 tax returns?
  • Should partners be obligated to pay the partnership for their share of the tax assessed at the partnership level?
  • Will there be a need for distributions to cover tax and costs to be incurred by partners if the partnership is opting out? 
  • Should partners be required to file amended returns for any audit adjustment if no opt-out election is made?
  • How should the tax liability be handled for new partners that were not partners for the year under audit?

Contact your account director at Schenck to discuss how these new partnership audit rules will affect you. You should also coordinate with your attorney to review your operating agreement and to make any necessary changes outlined above. We can work with your attorney to determine if the revisions made to the operating agreement appropriately address the new partnership audit rules.

Questions? Contact Shane Wheeler, CPA, JD, supervisor, at 920-455-4280, or any member of Schenck’s Partnership team:
Brian Strnad, CPA, Shareholder  |  920-455-4208
Mark Vance, CPA, Shareholder  |  414-465-5535
Michael Zuleger, CPA, Senior Manager  |  920-997-5333
Ryan Sonnenberg, CPA, Manager  |  920-455-4150

Shane Wheeler, CPA, JD, is a supervisor with Schenck who focuses primarily on tax planning, compliance, and business consulting for closely held businesses and individuals. He is a member of the firm’s Manufacturing & Distribution and Real Estate & Construction teams.