On November 2, 2015, President Obama signed into law The Bipartisan Budget Act of 2015, P.L. 114-74. The bill includes one set of rules for auditing partnerships. Prior to these law changes and since 1982, the partnership audit universe was largely divided between TEFRA partnerships and non-TEFRA partnerships. Non-TEFRA partnerships are partnerships with 10 or fewer partners and which do not include a flow-through entity or trust as a partner. These partnerships are audited in conjunction with the individual partners. TEFRA partnerships are partnerships with 11 or more partners or partnerships with a flow-through entity or trust as a partner. The IRS must determine the tax treatment of any TEFRA partnership item at the partnership level. However, audit adjustments are flowed through to the “audit year” partners and the tax liability of each partner is recomputed for year audited.
In 1997, Congress created a third type of partnership audit regime for electing large partnership (“ELP”). An ELP is any partnership making an election to be treated as such and that had 100 or more partners in the prior tax year. Under the regime, audits are conducted at the partnership level. Partnerships adjustments flow-through to the “adjustment year” partners and the recomputed taxes are paid in the adjustment year.
The IRS faced significant difficulty auditing TEFRA and ELP partnerships. For ELPs, it often takes the Service months to identify the partner representing the partnership because these individuals are not disclosed on the ELP return. For TEFRA and ELP audits, even if the Service makes a large adjustment, it often ends up failing to collect the additional tax because of difficulty tracing who actually paid tax on the partnership income.
In response to these concerns, the Bipartisan Budget Act of 2015, drawing heavily on legislation developed by former Representative Dave Camp (R-MI), eliminates the TEFRA and ELP rules and replaces them with a new streamlined system. Under the new rules, the IRS would examine a partnership’s items of income, loss, deduction or credit at the partnership level. Any adjustments would be taken into account by the partnership (not the partners) in the year of the adjustment (not the year examined). The adjustment will be taxes at an imputed underpayment rate equal to the highest rate of tax in effect for partners in the year reviewed. Thus, the partners of the partnership in the year of the adjustment will bear the burden of the adjustment. The partners would not have joint and several liability for the taxes, interest and penalties.
The partnership may demonstrate that the adjustment would be lower if based on partner level information, including amended returns filed by partners, lower tax rates apply to certain partners (including corporations or tax exempt organizations) and the character of the income subject to adjustment (capitals gains or qualified dividends). Alternatively, the partnership may elect to issue amended Form K-1s to the “reviewed year” partners. The partners would then determine the additional tax owed for the year reviewed and pay the tax (along with interest and penalties) with the tax return for the adjustment year. The election must be made within 45 days of the final notice of the partnership adjustment. Under the elective approach, the partners must pay underpayment interest at a higher rate (federal short term rate plus 5% instead of 3%).
Under the new rules, the TEFRA tax matters partner is replaced with the partnership representative, who does not have to be a partner. The representative has authority to resolve partnership audit issues and the resolutions will be binding on the partners.
Under the new law, partnerships with 100 or fewer partners may opt-out of the new audit process and would be audited according to the rules generally applicable to individuals. However, any partnership with a partnership or trust as a partner will remain subject to the rules. Additionally, for S corporation partners, each shareholder is treated as a partner for purposes of the opt-out rules.
The new rules apply for partnership taxable years beginning after December 31, 2017, however partnerships may elect to apply the new rules to partnership taxable years beginning after November 2, 2015 and before January 1, 2018.
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