Background. In October, Congress enacted the Bipartisan Budget Act of 2015 (the Act), which contained changes to the IRS partnership audit techniques. These changes were in response to a growing concern that the IRS was unable to effectively and efficiently audit partnerships due to various cumbersome rules and procedures, especially as they relate to multi-tiered partnerships. See the full text of the Act at https://www.congress.gov/114/bills/hr1314/BILLS-114hr1314eah.pdf.
In 2012, only 0.8% of “large” partnerships were audited as compared to more than 27% of large corporations. The Act drastically changes the audit rules that apply to partnerships from a regime that passed through the partnership adjustments to the partners to collect the tax and any applicable penalties and interest from them, to a regime that allows for collection at the partnership level. Revenue to be collected over ten years from the new rules is projected to exceed $9 billion.
Current Rules. Prior to the Act, most partnerships with 10 or more partners were audited under the unified audit rules created by the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). Under the TEFRA audit rules, the IRS conducts a single administrative proceeding at the partnership level to determine the adjustment, if any. Once the adjustment has been calculated, the IRS then recalculates the tax liability for each individual partner in the partnership.
Before the adoption of the Act, partnerships with 100 or more partners (“large” partnerships) could elect to be audited under separate more streamlined rules. This meant, for example, that the IRS determined the necessary adjustment at the partnership level which then flowed through to the partners in the year the adjustment became effective, instead of affecting prior year returns. However, many large partnerships refused to elect such treatment for audit purposes, resulting in very few audits of such partnerships because calculating each individual partner’s tax liability was extremely time-consuming. To promote more audits of large partnerships, Congress agreed on the Act.
New Rules. Under the Act, which becomes effective for tax returns filed for tax years beginning after December 31, 2017 (although an election can be made to apply the new rules sooner) all partnership adjustments to income, gain, loss, deductions, or credits are calculated at the partnership level. More importantly, all tax liability resulting from such adjustments is assessed and collected at the partnership level. Under the Act, partnerships will be required to pay tax on the “imputed underpayment.” The imputed underpayment is defined as the net of all adjustments multiplied by the highest individual or corporate tax rate (39.6% being the highest individual rate). Partnerships may request that the IRS reduce the imputed underpayment. A reduction in the imputed underpayment is likely if the partnership can show any of the following:
- All or a portion of the imputed underpayment is allocable to a partner who is a tax-exempt entity (thus tax might not be owed).
- All or a portion of the imputed underpayment is ordinary income and would be allocable to a C corporation, or all or a portion of the imputed underpayment is capital gain or dividend income and is allocable to an individual partner.
- One or more of the partners filed an amended return reflecting the amount of the underpayment for the tax year being reviewed.
Under the Act, the partnership (rather than the partners) will be required to pay the imputed underpayment. This means that the economic burden of the underpaid tax of prior tax years will be borne by current partners. However, the Act does provide that partnerships may choose an alternative mechanism for payment of the imputed underpayment by the partners. If the partnership chooses this alternative upon receiving a notice of final partnership adjustment, the partnership must then provide a statement reflecting the partner’s share of the adjustment to each partner who was a partner during the year reviewed. The partnership must elect the alternative mechanism for payment no later than 45 days after the date of the notice of final partnership adjustment.
Further, certain “small” partnerships may elect out of this new audit regime. Those generally include partnerships that (1) have fewer than 100 partners, (2) have as partners only individuals, estates, C corporations, or S corporations, and (3) follow certain other procedural requirements.
This is only a brief summary of some of the new partnership audit rules contained in the Act, and none of this should constitute legal advice. If you would like additional details about the Act and how its provisions may affect your personal situation, please do not hesitate to contact Christopher L. Nuss at 515-242-2432 or Bill Brown at 515-242-2412.