IRS Proposes Centralized Partnership Audit Regulations

On January 18, the IRS and Treasury Department issued proposed regulations implementing a centralized partnership audit regime set to take effect in 2018. This new approach to partnership audits was enacted by the Bipartisan Budget Act of 2015 (BBA), as amended by the Protecting Americans from Tax Hikes Act of 2015.

In a dramatic departure from current practice, the new rules will impose tax liability resulting from an audit adjustment at the partnership level rather than allowing it to flow through to partners in the year under examination (the “reviewed year”). What’s more, this so-called “imputed underpayment” will be calculated based on the highest individual or corporate tax rate for the reviewed year, without regard to partner-level tax attributes that would otherwise reduce their tax liability. And because the partnership must take this tax liability into account in the year an adjustment becomes final (the “adjustment year”), current partners may be responsible for tax liabilities that should have been borne by former partners.

The BBA provides two ways for partnerships to obtain relief from these harsh results: First, partnerships with 100 or fewer partners (see below) can elect out of the centralized audit regime. And second, a partnership may avoid the rules by “pushing out” tax adjustments to the responsible partners.

Also, under current rules, partnerships designate a “tax matters partner” to act on their behalf in dealing with the IRS, but the other partners have rights to notice and to participate in any audits or other IRS proceedings. Under the new rules, partners will no longer have any meaningful rights when it comes to dealing with the IRS. Instead, partnerships will be required to name a “partnership representative,” who has the sole authority to act on the partnership’s behalf and whose actions are binding on both the partnership and its partners.

Highlights of the Proposed Regulations

The proposed regulations provide guidance on the scope of the centralized audit regime as well as procedures for determining amounts owed by the partnership or its partners, electing out, filing administrative adjustment requests, and designating a partnership representative. Here are some of the highlights:

• The centralized audit rules apply to a broad spectrum of adjustments to a partnership’s income, gain, loss, deduction or credit, as well as to any partner’s distributive share of such items.
• To elect out of the centralized audit regime, a partnership must have 100 or fewer partners, all of which are eligible. An eligible partner is any individual, C corporation, foreign entity that would be treated as a C corporation if it were domestic, S corporation or estate of a deceased partner. Generally, a partnership meets the 100-partner threshold if it’s required to furnish 100 or fewer K-1s for the relevant tax year. However, special rules provide that 1) the shareholders of an S corporation partner count toward the 100-partner threshold, and 2) husbands and wives are not treated as a single partner for these purposes.
• In lieu of paying an imputed underpayment, a partnership may elect to push out adjustments to its reviewed year partners. The election must be made within 45 days after the IRS mails the final partnership adjustment (FPA), and the partnership must furnish and file statements reflecting reviewed year partners’ shares of the adjustment. A valid election shifts liability to the reviewed partners, who must increase their taxes for the year in which the statement is furnished by an amount that reflects the increased tax they would have paid in the reviewed year had the adjusted items been reported correctly.

Pushing out adjustments involves some time and effort, but because it allows for consideration of partner-level tax attributes, it has the potential to reduce the overall tax impact of an audit adjustment. Note that the IRS reserved certain issues pending additional comments, including whether a pass-through partner should be allowed to flow adjustments through to its owners.

Next Steps

Between now and the end of 2017, partnerships and their advisors should familiarize themselves with the new rules, including any changes made once they’re finalized, and determine whether they’re eligible to elect out of centralized audits. Partnerships that will be subject to the new rules should weigh the costs of pushing out adjustments to reviewed year partners against the potential tax savings.

For more information, read:

• “Centralized partnership audit rules proposed,” Journal of Accountancy, Jan. 19, 2017
• “Proposed Centralized Partnership Audit Regulations Issued,” CCH Tax Day Report, Jan. 19, 2017
• “Proposed regs on new partnership uniform audit rules: “Push out” election,” Thomson Reuters Tax & Accounting News, Jan. 23, 2017