We recently discussed the much-anticipated proposed Treasury Regulations, providing guidance on a variety of issues relating to the new partnership audit rules (the “Audit Rules”) and the “regulatory freeze” imposed by the White House on these and all other regulations that had not yet been published as of the presidential inauguration. But why spend time reviewing frozen regulations? First, it seems likely that these regulations will ultimately be implemented, given the fact that the partnership audit rules are, in fact, in the Internal Revenue Code, only awaiting their 2018 effective date. Not issuing these regulations would leave only the statutory provisions in the Code, without any guidance whatsoever on many critical issues relating to these rules. Second, and perhaps more importantly, this is the only guidance we have.
Included in these regulations is guidance relating to the ability of a partnership or LLC to completely opt-out of the Audit Rules. The basic statutory rule is that only partnerships and LLCs with 100 or fewer partners, all of which are individuals, corporations, or estates of deceased partners, can make the election to opt-out of the Audit Rules. The proposed regulations make it clear that a partnership determines how many partners it has by counting the number of K-1s required to be issued. For example, if a partnership has issued two K-1s to the same individual (which technically is not in accordance with the instructions) because they serve as both a general and a limited partner, this only counts as one partner for purposes of the 100-partner limitation because the two K-1s are not technically “required.” On the other hand, a husband and wife (who were treated as a single partner under the TEFRA audit rules) will be counted as two partners for purposes of this limitation.
One area of concern had been whether certain trusts, such as grantor trusts, and “disregarded entities” would be a permitted partner for a partnership wanting to opt-out of the new rules. Both of these types of entities are, for almost all purposes, disregarded for federal income tax purposes. The thought was that, for instance, a single member LLC disregarded for tax purposes would be a permitted partner for the opt-out rules, provided that the owner of the disregarded LLC was a permitted partner (such as an individual). The proposed regulations specifically decline to permit this. In most cases, if opting out of the Audit Rules was important enough, the partnership interest could be transferred back to the permitted owner in most cases without incurring a tax. Of course, doing so would unwind the benefit of setting up the trust/disregarded entity structure in the first place.
Finally, for those partnerships considering whether opting out will reduce the chance of an audit, the summary of the regulations makes it clear that the IRS intends to audit partnership regardless of whether or not they have opted out. Since partnerships that opt-out will only have one or, in the case of partnership with an S corporation partner, two levels of owners to assess, and will have the taxpayer identification numbers of all these partners. This will make it relatively easy, compared to the current rules, for the IRS to audit even those partnerships that elect to opt-out of the Audit Rules. It seems clear, therefore, that while opting out can be beneficial to a partnership under certain circumstances, reducing the risk of an audit will not be one of those benefits.