How the New Partnership Audit Procedures May Affect Your Partnership and How You Can Plan

The following article, which has been slightly modified for publication here, about partnership audit procedures was first published in December, 2018.  The article is included here as a representative sample of the expertise of KatzAbosch’s professionals in the subject matter covered by the article.  The article has not been updated to take into account subsequent developments, if any.  Accordingly, the article is not intended to be a description of the current state of affairs in this area or to provide advice to viewers.  The article should not be relied upon in making any financial, legal, accounting, operational or other decision.

This is to inform you about the partnership audit procedures that apply for partnership tax years beginning after 2017. These rules are designed to collect taxes and penalties from the partnership rather than passing the audit adjustments to the ultimate partners. Partnerships must designate a partnership representative (PR) with a substantial presence in the U.S., but the PR need not be a partner. If the PR is an entity, the partnership then must also designate an individual to act on behalf of the PR entity. The PR will have the authority to bind the partnership; if no PR is appointed, the IRS will designate one.

There are three alternatives under the new audit rules.

1) Default rules – partnership pays the tax, penalties, and interest.

2) The partnership elects out of the new rules – the partnership is eligible if:

a. the partnership is required to furnish 100 or fewer statements to partners or nominees for the year, treating each statement that must be furnished to an S corporation shareholder as a separate statement, and

b. the partnership only furnishes statements to individuals, C corporations, foreign entities that would be treated as a C corporation if it were a domestic entity, S corporations, or estates of a deceased partner. They cannot issue statements to other partnerships, trusts, foreign entities not described above, disregarded entities, estates of individuals other than a deceased partner and any person that holds an interest on behalf of another person.

A partnership must make the election on its timely filed return for the tax year to which the election applies and must notify its partners of the election within 30 days of the day it makes the election.

3) The partnership makes a “Push-Out” election

a. The “Push-Out” election can be made after the audit is well underway. This election can be costly and must be made within 45 days after the date of the notice of final adjustment.

Under the partnership audit procedures, the IRS may make adjustments to (i) any item or amount relating to the partnership that is relevant in determining the income tax liability of any person and (ii) any partner’s distributive share of any such item or amount. In general, an imputed underpayment will be determined (a) by netting all partnership adjustments for the reviewed year and (b) applying the highest individual or corporate tax rate to the adjustments. Special rules apply so that items of different characters aren’t netted against each other.

Partnership and limited liability company (LLC) operating agreements are recommended to be reviewed and updated with the help of legal counsel. Below is a list of items to consider (not meant to be all inclusive).

• The designation and removal of the partnership representative.

• The designation and removal of the individual that may be appointed if the partnership representative is an entity.

• Limiting the partnership representative’s powers to make elections, settle audits, or extend the statute of limitations without partner participation or, alternatively, having partners acknowledge the partnership representative’s broad powers

• Appropriate indemnifications for the partnership representative

• Deciding whether and when the partnership will “pay” (perhaps under a specified dollar amount”, “push out” or “elect out”

• Restrictions on transfers of partnership interest to entities that are ineligible partners (for purposes of the “elect out” alternative)

• The requirements for the partnership representative and partners to obtain and provide information that may reduce the partnership’s imputed underpayment liability

• The potential for filing amended returns by those who were partners in the reviewed year(s)

• If the partnership “pushes out,” the ability to contact former partners

• Partners’ notice and participation rights in connection with federal or state audits

• Extending partner indemnification obligations for a period of time after the sale of a partnership