The IRS has issued proposed regulations on new tax audit rules for partnerships. The regulations are scheduled to become effective January 1, 2018. The partnerships, including limited liability companies, should consider amending their partnership or LLC agreements to address the new rules.
Under the new audit rules, the partnership itself will be responsible for paying additional tax assessed by the IRS as a result of an examination. In the past, the additional tax was assessed on the individual partners. The new rule can create an issue, since the partners who benefitted from an aggressive tax position taken the year under audit, but who are no longer partners when the audit takes place, will not have to pay their share of any audit assessment. On the other hand, the remaining partners, including any new partners, will be responsible for the assessment since it will be paid out of partnership assets when the audit concludes. Per the new rules, any tax resulting from an audit adjustment is calculated by multiplying the net increase in income resulting from the audit by the highest federal income tax rate, which is currently 39.6%, the highest marginal individual tax rate. There are few options available to a partnership in regard to the new audit rules.
The first way is to make an “opt-out” election. A partnership with 100 or fewer partners can “opt-out” completely from the new rules. However, a partnership with a trust as a partner is ineligible to opt-out. To opt-out, a partnership must make a Section 6221 election on its information return for the year for which it wishes to opt-out and provide the IRS with the names and taxpayer identification numbers of its partners and of the shareholders of any S corporation partner. Partnerships that opt-out will be allowed to have audits performed at the partner level but will remain subject to the new partnership representative rules discussed below.
The second way is to make a “push-out” election. Partnerships can also elect not to be subject to the new audit rules. If the partnership elects to do so, the partners are permitted to calculate any additional tax as though the adjustment had been made in the year under audit taking into account the partners’ actual tax rates instead of the highest federal tax rate. If this election is made timely, the adjusted income information is issued to those who were partners in the year under audit rather than in the year that the audit is performed. New partners, therefore, will not be responsible for taxes of partners who have left the partnership after the year under audit. However, with this election, interest on any underpayment will be assessed at a rate that is 2% higher than if the partnership had paid the tax.
The third way to avoid having the partnership pay any audit assessment is to agree to file amended returns under Internal Revenue Code (IRC) Section 6225. Since the entire amount of any assessment would be reflected on the partners’ amended returns, the partnership would not bear the assessment. This is useful for partnerships with partners who have different tax rates, since each partner would be liable to pay his or her share of the assessment at his or her own rate. The partners’ agreement to file amended returns should be contained in the partnership or LLC agreement.
For more information about this article, please contact our tax professionals at taxalerts@windes.com or toll free at 844.4WINDES (844.494.6337).