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The Bipartisan Budget Act of 2015, signed into law in November 2015, substantially changes the way the IRS may audit partnerships and, unless they’re not treated as partnerships for tax purposes, multimember limited liability companies (LLCs). The goal of the changes is to streamline the current partnership audit process.
The IRS acknowledges that partnership audits are difficult because the process can require auditors to calculate each partner’s share of any adjustment.
The new rules generally go into effect for tax years beginning after December 31, 2017. However, partnerships may generally be able to elect to apply the rules for tax periods starting after November 2, 2015, and before January 1, 2018.
Adjustments at the partnership level
In the most significant change, tax audits may be done and any resulting adjustments may be determined and collected at the partnership — rather than the partner — level. However, the law provides several ways some partnerships can opt out of this. This contrasts with most auditing procedures in place before the law passed. Under the old rules, for partnerships of up to 10 partners, the IRS generally audits individual partners.
For most partnerships of more than 10 partners, the IRS typically conducts what’s often referred to as a TEFRA (named after the Tax Equity and Fiscal Responsibility Act of 1982) proceeding to resolve issues best determined at the partnership level. Adjustments flow for the year of the audit to the partners, who may have to file amended returns for the year.
For audits of Electing Large Partnerships (ELPs), which are partnerships that have at least 100 partners, adjustments generally flow through to the partners for the year in which the adjustment takes place, rather than the year under audit.
The new rules provide a single set of procedures for most partnerships. In addition, many adjustments would be assessed in the year the audit is completed, and not for the year under review.
However, partners typically won’t be subject to joint and several liability for partnership adjustments. (Under joint and several liability, each party is independently liable for the entire amount of a relevant claim.)
In addition, the law provides some exceptions. Rather than have adjustments assessed at the partnership level, a partnership can decide to issue adjusted Schedules K-1 for the reviewed year to its partners who were members of the firm during the year under audit. This could include partners who are no longer with the firm. The partnership must elect to do this no later than 45 days after the adjustment is made. The partners for the year under review would need to pay any additional tax and amend their returns for that year.
In addition, partnerships of 100 or fewer partners typically can opt out of partnership-level audits, so long as its partners are either individuals, S corporations, estates, C corporations or foreign entities that would be treated as C corporations. The partnership would need to make this election each year.
Partnership members should review their operating agreements to see what revisions they should make in light of these changes. For instance, since the new rules can bind partners to a decision made by one representative who has sole authority to act on behalf of the partnership, partnership members should define the limits of this person’s role and authority. The agreements also will need to account for the fact that, under the new rules, partners could be liable for adjustments stemming from years in which they weren’t members of the partnership.
Working it out
The revised partnership audit rules are complex. They are expected to make it easier for the IRS to perform audits so large partnerships and multimember LLCs may be at a greater risk of being audited. Additional guidance is expected to come out on the new rules this summer. If you have any questions on these changes or how it will impact you, please call us at 302.225.0600, or click here to contact us.