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Partnership Audit Rules Update

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Rödl & Partner Tax Matters Vol 2018 – 11, published in December 2018

 

Changes to the partnership audit regulations (described in Rödl Tax Matters Vol 2016-7) are effective for tax years beginning in 2018. This alert is intended as a reminder of required or recommended actions and related considerations.

 

SUMMARY OF THE NEW PARTNERSHIP AUDIT REGIME

Under prior rules, if an IRS audit of a partnership resulted in adjustments to income, such adjustments were allocated to the partners with tax assessed at the level of each partner. This was considered inefficient from the government’s point of view, particularly for large partnerships with numerous partners. Under the new rules, the “default” position is assessment of tax for audit adjustments at the partnership level, with the partnership itself liable for tax, interest and penalties in the year of the adjustment.

 

In practice, results under this new system could be onerous in that tax is computed at the highest individual or corporate rates and the cost is borne by the current partners, even if those are different from the partners for the year audited.

 

Most partnerships will elect to take advantage of one of the two exceptions to the default assessment at the partnership level.  In the case of a qualifying partnership with 100 or fewer partners who are all “eligible” partners, an annual election can be made to elect out of the rules. Unfortunately, this election cannot be made if there is an ineligible partner – which includes another partnership, an LLC treated as a partnership or a disregarded entity. The second exception is a “push-out” election that can be made within 45 days of an audit adjustment. The push-out election requires the partnership to communicate adjustments to the partners. The partners then have a limited period of time in which to pay the tax, and are assessed interest on underpayments in an amount two percentage points higher than the normal rate.

 

Each partnership must appoint a “partnership representative” with broad authority to act on behalf of the partnership with respect to tax audits and the IRS, including the authority to make the elections described above. The representative does not need to be a partner, but must have “substantial presence” in the U.S.


DEADLINES AND ACTIONS TO CONSIDER

Tax returns filed for 2018, including short tax years beginning in 2018, require the appointment of a “partnership representative” unless the partnership is eligible and chooses to elect out. Qualifying partnerships should consider “electing-out” of the new audit rules. To be effective, the annual election must be made on a timely filed (including extensions) partnership return for the year. All partners must have a tax identification number (TIN), and the election must be communicated to the partners within 30 days. The IRS has published a draft version of new Schedule B-2 (Form 1065) related to the election out.

 

If no elect-out election is made or is not allowable, consideration should be given to implementing procedures to ensure that a “push-out” election is evaluated and, if favorable, made within 45 days of a final audit adjustment.

 

In consultation with your legal advisor, every partnership agreement should be evaluated to determine:
  • Whether amendments are necessary or advisable for the purposes of addressing how the representative is appointed or replaced, 
  • The partnership representative’s level of discretion to make or not make elections,
  • Notice requirements,
  • Whether admission of non-eligible partners is permitted, and 
  • Any other considerations specific to the partnership

 

Partnership agreement provisions detailing tax audit procedures and elections are likely to be particularly important to new partners.

 

Note that it is expected that banks and other lenders may require loan covenants mandating “electing-out” of the new partnership level audit rules.

 

For more information, contact your Rödl & Partner representative.

 

 

This publication contains general information and is not intended to be comprehensive or to provide legal, tax or other professional advice or services. This publication is not a substitute for such professional advice or services, and it should not be acted on or relied upon or used as a basis for any decision or action that may affect you or your business. Consult your advisor.

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