Significant change to partnership audits

The budget bill signed by President Obama on Nov. 2 includes a significant change in the way partnership audits are handled. Partnership audits are increasingly an issue for the IRS as more businesses are set up as partnerships (including LLCs), and more partnerships and LLCs have hundreds or even thousands of partners.

Under the current audit rules (which are generally still effective until 2018), there are basically three different types of partnership audits. Electing Large Partnerships (ELPs) have audits done at the partnership level, and any adjustments are reflected on the partners’ current year return (as opposed to amending prior year returns). An ELP must have more than 100 partners and elect to be treated as such. Partnerships with more than 10 partners are audited under the unified partnership audit rules, and the results of the audit are binding on the partners. After the audit, the IRS recalculates the tax liability of each partner and makes an assessment. Although the IRS audits the partnership and not the partners under the unified rules, any assessment must be made (and collected from) the individual partners. A partnership with fewer than 10 partners is generally audited by auditing the individual partners. Rules regarding who gets notice of the audit vary among the different types of partnership audit. A Government Accounting Office report issued last year determined (and the IRS has long complained) that these rules make it difficult to audit partnerships and LLCs, especially those with large numbers of partners.

The budget bill eliminates these distinctions and provides for a single set of rules governing partnership audits. After the effective date of these rules, the IRS will examine the partnership’s return, and the partnership will (with a number of exceptions) be responsible for any adjustments in the year that the audit was completed, or in the year that any judicial proceeding relating to the audit becomes final. The partnership will generally pay tax at the highest individual or corporate tax rate, although procedures will be available for a partnership to show that this rate is not appropriate because, for instance, income is allocable to partners with a lower rate. Although prior proposals had included “joint and several” liability of partners with respect to these taxes, this provision is not included in the final bill.

There are a number of ways that a partnership can essentially opt out of these rules. An election will be available whereby the partnership can issue adjusted information returns to its partners instead of having the partnership pay the tax liability. Partnerships with 100 or fewer partners that have only certain types of partners (essentially individuals and corporations) would be allowed to opt out of these rules and have audits performed at the individual partner level.

While the new rules are applicable to tax years beginning after 2017, some partnerships can elect to have these rules effective as of Jan. 1, 2016. Existing partnerships should review their agreements to determine what, if any impact the new rules will have on them. The fact that these provisions were designed to raise $9 billion over the next 10 years is a clear sign that more partnership and LLC audits are coming soon.

For additional information, please contact the attorney listed below.