Limited partnerships and limited liability companies taxed as partnerships have long been the “entity of choice” for many closely held businesses. Unlike corporations, these entities pay no tax themselves and allow considerable flexibility in both ownership and operation.
As partnership structures over the years became more common, the IRS was challenged to consistently and fairly administer partnership law. In response, Congress passed the Tax Equity and Fiscal Responsibility Act (TEFRA) in 1982 to establish unified IRS audit rules for entities taxed as partnerships.
These rules required that tax treatment of partnership items be consistent for all partners. Each partner’s share of any IRS audit adjustments would impact his or her share directly in the tax year under audit. Beginning in1997, Electing Large Partnerships (those with more than 100 partners) could adopt streamlined audit procedures that allowed adjustments from prior years to be taxed in the year the audit was concluded. Partnerships with fewer than ten individuals were not subject to these rules.
Even though TEFRA was passed to help the IRS consistently and fairly administer the law, it often created more problems than it solved. Due to its shortcomings, it will be replaced by new partnership audit rules codified in 2015. The law becomes effective for tax years beginning after December 31, 2017, but existing partnerships may elect to apply the law to the years beginning after November 2, 2015, the date of enactment.
These rules dramatically change how partnership-audit adjustments are administered. Audit adjustments will now be assessed in the year the audit concludes, instead of in the year under audit. This raises the concern that newly admitted partners could potentially bear the costs of prior-year audit issues. New partners will want to take steps to indemnify themselves against adjustments arising in periods that predate their ownership. Also, new partnerships will need to draft their documents with these new rules in mind.
Now, with the enactment of this new law, it can no longer be said that the entity “pays no tax.” The IRS collects the tax, interest and penalties directly from the partnership. The tax is computed by netting all of the audit adjustments and applying the highest individual or corporate tax rate, unless the partnership elects to shift the liability back to the partners. In that case, the partners must recalculate their own tax and pay interest at a higher rate.
The new audit rules cast a wider net and apply to all partnerships, regardless of the number of partners.
Qualifying entities with fewer than 100 partners may elect to opt out of the new rules on an annual basis. It is important to note that partnerships owned by other partnerships or trusts will not qualify for the opt-out.
Finally, the law requires that the partnership select a “partnership representative.” The representative need not be a partner, but will have sole authority to act on behalf of the partnership before the IRS. Great care should be taken in selecting this representative, since partners will have no right to participate in, or receive notice of, IRS action.
There is no doubt that the new rules will create many planning opportunities, as well as pitfalls. The Congressional Budget Office projects the new rules will raise $9 billion over the next ten years. Accordingly, it is imperative that partnerships coordinate the efforts of their legal and accounting advisors to successfully navigate these new audit regulations.
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