On November 2, 2015, President Obama signed the Bipartisan Budget Act of 2015 containing new partnership audit rules effective for taxable years beginning after December 31, 2017. However, partnerships may elect to apply these new partnership audit rules immediately.
When a partnership is audited, under current partnership audit rules, any adjustments made at the partnership level flow through to the partners for the audited tax year. Under the new rules, when a partnership is audited, any adjustments made at the partnership level will be borne by the partnership in the current year. As a result, a partnership will need to satisfy any adjustments from its own balance sheet or from its current partners, some of whom may not have been partners during the audited tax year. For example, if a partnership is audited in 2015 and is assessed for underpayment for 2012, the partners of its partnership are responsible for satisfying this adjustment in 2015 even if they were not partners in 2012.
In order to reduce potential inequities, the new partnership audit rules permit a partnership to elect, following an adjustment, to send adjusted Schedule K-1s reflecting audit adjustments to those persons who were partners of the partnership during the tax year that was audited. Each partner in the audited year will then be required to reflect the adjustment on their individual returns in the current year. The partners, however, are required to pay a higher rate of interest on the underpayment using this procedure.
The new partnership audit rules will apply to all partnerships other than certain partnerships with 100 or fewer partners that elect to “opt-out.” The “opt-out” will be available provided that each partner is an individual, corporation or the estate of a deceased partner. Importantly, however, the “opt-out” election will be unavailable to lower-tier partnerships in tiered partnership structures.
The new partnership audit rules mean that partnership agreements, including those currently in effect, will need to be evaluated to determine whether the new partnership audit rules are appropriately addressed. For example, a well drafted partnership agreement should determine how the cost of a tax liability paid in the current year should be shared among partners, when it relates to income earned and cash possibly distributed during the audited year. In light of this possibility, partnerships may need to contemplate including a provision in the partnership agreement that will either (i) indemnify partners against the liabilities of transferring partners; or (ii) require the partnership to elect to utilize the adjusted Schedule K-1 procedure. Partnerships that wish to “opt-out” should also consider including appropriate language to effectuate the election within the partnership agreement.