Tax year 2018 begins a new regime of partnership audit rules, casting off the old TEFRA regime of small and large partnerships in favor of a streamlined audit process. While this may sound like the type of mind-numbingly technical issue to be ignored, it really isn’t. Due to some harsh changes in the audit process, the new system requires careful consideration on how a partnership desires to be treated in the event of audit; a decision that needs to be made when filing each tax return, not when an audit occurs.
Under TEFRA, small partnerships (mostly partnerships with less than 11 partners) and their partners were audited separately. If a small partnership was audited, it would first be conducted at the partnership level, adjusted K-1s would be issued for the year audited, and the partners would each amend their personal taxes to reflect the change. Large partnerships were similar, except the IRS would recalculate each partner’s liability separately for any changes and assess the partners directly. All of this would be coordinated through a Tax Matters Partner, designated on the partnership’s tax return.
The new streamlined audit rules change everything. Small and large partnerships are now gone, as is the Tax Matters Partner. Under the new approach, audits are conducted directly at the partnership level through a Partnership Representative. The Partnership Representative need not be a partner or member, and may be designated by the IRS if a partnership fails to do so. As under TEFRA, adjustments are made based on the year under audit; however, the adjustments are made to the current year tax return, not the year under audit. This can cause current partners to be held responsible for the tax liability of a former partner. Also, instead of the auditor calculating and assessing tax for each partner separately, the entire liability for all partners is assessed at the partnership level at the highest individual tax rate. This will cause additional tax liability if all the partners are not already in the maximum tax bracket.
A partnership can elect out of paying the tax directly as part of the audit process. The process involves sending out a simplified Form K-1 to each partner, who then files a simplified adjusted tax return. However, the adjustment sill applies to the current year, not the year under audit. While this option allows partners to only pay their marginal rates, it can still subject current partners to income attributed to former partners.
Fortunately, many partnerships can elect out of the new streamlined audit procedures when filing their tax returns. They must appoint a Partnership Representative, but a partnership that elects out will be allowed to issue amended K-1s to each partner, for the year being audited, for any adjustments made in the audit. Those partners would amend their tax returns for the relevant audit years, subjecting the original recipients of the income to any adjustments, and allowing them to pay only their marginal tax rate. However, not all partnerships can elect out of the new streamlined audit regime. To do so, partnerships must have no more than 100 partners and may not have any partnerships as partners.
While the new streamlined audit rules for partnerships do live up to their name, potentially reducing the costs to comply with an audit, they can significantly increase the tax cost of an audit adjustment. It can also apply the tax liability to partners that may not have originally reported the income or loss being adjusted. As such, the decision whether or not to elect out of the new regime should be seriously considered when filing each of a partnership’s tax returns, well in advance of an actual audit.
Should you have any questions on specific provisions of the new partnership audit regime please feel free to reach out to us for a consultation.
Written by Damien Falato, CPA, MST, CGMA, Tax Director