IRS Change to Partnership Tax Examinations May Require Action

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New IRS tax examination rules affecting partnerships (including most LLCs with multiple members) became operational for 2018. This new audit legislation was enacted in 2015, but its application was not effective until tax years beginning after December 31, 2017. These changes should be considered by every partnership.

 

The rules make major modifications to the way IRS adjustments to tax amounts of a partnership are assessed as well as the tax rates that will apply to them, although some partnerships may opt out of these provisions. It also creates a new position, the partnership representative, with exclusive broad-ranging authority to bind the partnership and its partners for all IRS matters.

 

Examination Changes

Unless a partnership is permitted to opt out of the new audit rules, an adjustment by the IRS now requires the partnership, not its partners, to pay the assessment. It will pay at the highest tax rate for the year at issue, currently 37%. Previously, adjustments were passed along to each partner who owned the entity in the year under audit. The income and tax of that owner was recalculated for that year, and assessment and collection made against that taxpayer individually. Now, changes are assessed to the partnership itself, in the year the audit is concluded.

 

A partnership's tax under this new regime will likely be greater than the total tax that would have been paid by its partners. For example, a partner who is an individual may be taxed in a lower bracket or have a net operating loss to reduce or eliminate tax. A partner that is a C corporation ordinarily pays only 21% tax. Also, partners may have left or joined the partnership since the year under audit, but only partners who own an interest when it is concluded share the economic impact of the adjustment.

 

Eligible partnerships may opt out of the new system. To quality, a partnership must have no more than 100 Schedules K-1. Each partner must be an individual, the estate of a deceased partner, a C or S corporation, or a certain type of foreign entity. No partner may be a partnership, trust, or disregarded entity (DE) such as a single-member LLC (even if the DE's income is taxed to an individual). If a partner is an S corporation, each shareholder within the S corporation (as well as the S corporation itself) counts as a K-1. If the opt-out is elected, calculations are determined at the partner level as in the past.

 

Partnership Representative

The new rules also replace the former "tax matters partner" with a new "partnership representative." This person holds vast powers, including the sole authority to act on behalf of the partnership and bind all partners on matters related to an examination. The representative need not be a partner - for example, a controller or other officer may be selected.

 

The partnership representative is not obligated to inform partners about audit proceedings or notify them before extending the statute of limitations, settling a tax dispute, or even pursuing litigation in Tax Court. The partnership, however, may place such obligations and restrictions on the representative either through the partnership agreement or by contract with the representative.

 

In light of these expanded powers, partners should carefully consider who they select as the partnership representative. Partnership agreements should be updated to designate a partnership representative and define his or her powers.

 

Contact your LMC professional for information about how the new partnership audit rules affect you. All our prior Alerts are available on the Updates page of our website. 

 

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