Under the current tax law, partnerships (including LLCs that are taxed as partnership) are flow-thru entities. The partnership does not pay tax on its income; rather, each partner is allocated his or her proportionate share of the income from the partnership and must pay income tax on such portion. It makes sense, then, that when a partnership tax return is audited by the IRS, any resulting adjustments are assessed against the persons who were partners in the audited tax year.
This regime, known by many as the “TEFRA Rules” is being overhauled by the IRS. Under the Bipartisan Budget Act of 2015 (the “BBA”), beginning for tax years after 2018, the TEFRA Rules will be repealed and a new, streamlined audit approach will be used. The key provisions of the BBA regarding partnership audits and adjustments are as follows:
- Partners will no longer participate in an audit. Only the partnership itself would participate though its “Partnership Representative.”
- Adjustments to a partnership tax return resulting from an audit will be taken into account by the partnership itself. That adjustment would be included in income in the year the audit takes place, not the tax year being audited.
- The tax imposed on the partnership as a result of an audit change will be calculated at the highest rate of tax in effect for the audited year.
- Any additional tax due as a result of an adjustment would be the responsibility of the partners in the year of the adjustment, not the partners in the audited tax year.
- Partnerships with less than 100 partners can elect to annually opt out of the streamlined audit procedure, and continue to be subject to the TEFRA Rules. To qualify to opt out, all of the partners must be individuals, C corporations, S corporations, or an estate of a deceased partner.
- If a tax liability has been imposed, a partnership may elect to shift the adjustment to the partners for the audited tax year. Notice must be given to the IRS and all of the partners within a specific time period.
The new rules under the BBA highlight the importance of a carefully drafted agreement among the partners. Existing Partnership Agreements and Operating Agreements should be reviewed to determine if the partners wish to include additional provisions to address the options available under the BBA. Specifically, any authority to make the election to shift the tax burden to the partners should be clearly documented.
For questions about this or any corporate or tax issues, please contact the attorneys at Paule, Camazine & Blumenthal, P.C.