IRS audits of partnerships were up 18.6% in 2015 over the previous tax year, according to the agency’s Fiscal Year 2015 Enforcement and Service Results. That’s the highest audit rate partnerships have experienced since 2006. By comparison, audits of large C corporations decreased by 8.8% in 2015.
The situation is expected to only get worse under the new rules for audits of partnerships that were enacted last November under the Bipartisan Budget Act of 2015. The new rules also apply to multimember limited liability companies (LLCs) that are treated as partnerships for federal tax purposes. (For simplicity, we’ll use the terms “partnership” and “partner” to refer to all entities and owners affected by the new partnership audit rules.)
Here’s what owners of these pass-through entities need to know, starting with the current partnership audit rules — which will remain relevant for a while longer.
Delayed Effective Date
The new partnership audit rules will generally apply to partnership tax years beginning after December 31, 2017. Affected partnerships may elect to apply the new rules to returns for partnership tax years beginning after November 2, 2015, and before January 1, 2018. But typically partnerships will be better off forgoing this election, since the new rules could make it easier for the IRS to audit them.
Current Rules for Partnership Audits
Before delving into the new partnership audit rules, it’s important to review the current rules, which will continue to apply until the revised rules go into effect starting with tax years that begin in 2018. The IRS follows three regimes for auditing partnerships under the Tax Equity and Fiscal Responsibility Act (the law that was revised by the Bipartisan Budget Act).
1. Unified Audit Rules. These rules generally apply to partnerships with more than 10 partners. Under this audit regime, the tax treatment of partnership items of income, gain, loss, deduction and credit, as well as any additions to tax or penalties from IRS-imposed adjustments to partnership items, is generally determined at the partnership level. In other words, the IRS can conduct a single partnership-level audit to resolve all issues for partnership tax items. However, once the partnership-level audit is complete and the resulting adjustments are determined, the IRS must recalculate the tax liability of each partner for the affected tax year.
2. Small Partnership Audit Rules. Unless the partnership elects to have them apply, the unified audit rules do not apply to a partnership with 10 or fewer partners, each of whom is an individual (other than a nonresident alien), a C corporation or the estate of a deceased partner. For these small partnerships, the IRS generally conducts separate audits of the partnership and each partner.
3. Electing Large Partnership Audit Rules. These rules provide simplified audit procedures for partnerships with 100 or more partners that choose to be treated as large partnerships for federal income tax reporting and audit purposes. For such electing large partnerships, disputes over the treatment of partnership tax items are resolved at the partnership level. Then any IRS-imposed partnership-level adjustments generally flow through to the partners for the partnership tax year in which the adjustments take effect (the adjustment year), as opposed to the year that was under audit.
New Partnership Audit Rules
The Bipartisan Budget Act of 2015 repeals the current unified partnership audit rules and the current electing large partnership audit rules. They’re replaced by a single streamlined set of rules that call for auditing partnerships and their partners at the partnership level. Small partnerships can elect out of the new rules. (See below.)
Under the new streamlined guidance, any IRS-imposed adjustments to partnership items of income, gain, loss, deduction or credit for the applicable partnership tax year (and partners’ shares of such adjustments) are determined at the partnership level. Subject to the exceptions outlined below, any resulting additions to tax and any related penalties are generally determined, assessed and collected at the partnership level.
Under the new rules, the IRS will audit partnership items and partners’ distributive shares for the applicable partnership tax year (called the “reviewed year”). Any adjustments are taken into account by the partnership (not the individual partners) in the adjustment year.
Partnerships generally must pay tax equal to the imputed underpayment amount, which generally equals the net of all IRS-imposed tax adjustments for the reviewed year multiplied by the highest individual or corporate tax rate in effect for that year.
Partnership Adjustment Options
Under the new audit rules, partnerships will have the option of demonstrating that an adjustment would be lower (more favorable to partners) if it were based on actual partner-level information for the reviewed year, rather than imputed amounts based solely on partnership information for the reviewed year.
Such partner-level information could include amended returns filed by partners, tax rates applicable to specific types of partners (for example, individuals vs. C corporations and tax-exempt entities) and the type of income subject to the adjustment (for example, ordinary income vs. capital gains and qualified dividends).
As an alternative to taking an adjustment into account at the partnership level, the partnership can elect to issue adjusted Schedules K-1 for the reviewed year to its partners. In that case, the partners would take the adjustment into account on their individual returns in the adjustment year through a simplified amended return process. Schedule K-1 is the information return that must be provided to each partner. It shows the recipient partner’s share of all partnership tax items and includes other information needed to prepare that partner’s separate federal income tax return.
Finally, the partnership also has the option of initiating an adjustment for the reviewed year, such as when it believes an additional tax payment is due or a tax overpayment was made. The partnership would generally be allowed to take the adjustment into account either at the partnership level or by issuing adjusted Schedules K-1 to the partners.
As a result of the new rules, partners generally must treat each partnership item of income, gain, loss, deduction or credit in a manner that is consistent with the treatment of the item on the partnership return.
Exception for Small Partnerships
Similar to the provision in the current audit rules that exempts most small partnerships (with 10 or fewer partners) from the unified audit rules, the new rules allow eligible partnerships with 100 or fewer partners to elect out of the revised rules for any tax year. To be eligible for this election, all partners generally must be individuals, C corporations, foreign entities that would be treated as C corporations if they were domestic entities, S corporations or estates of deceased partners.
If the IRS audits a partnership that has elected out of the new rules, the partnership and its partners will be audited separately under the audit rules applicable to individual taxpayers.
Managing Audit Risks
Although the new partnership audit rules are complex, they’re expected to make it easier for the IRS to audit large partnerships. When they go into effect, businesses that are set up as partnerships and multimember LLCs could be at a greater risk of being audited.
The IRS is expected to issue additional guidance on the rules, and it’s currently asking for comments to assist in the development of this guidance. Feedback is due to the IRS by April 15, 2016, and additional guidance is expected to come out during the summer. Contact your tax adviser for insight into how these changes are likely to affect your business.