New rules that took effect on January 1, 2018 replaced existing rules for IRS audits of entities classified as partnerships for federal income tax purposes. Such entities include not only partnerships, but also limited liability companies and S corporations. In this article, all such entities are referred to as partnerships and their owners are referred to as partners. Though the rules have only recently become effective, they were passed as part of the Bipartisan Budget Act of 2015.
Under the prior rules, partnership audits were unified proceedings in which the entity’s “tax matters partner” (TMP) was in charge of coordinating the audit and any judicial proceedings that took place in connection with it. The IRS was generally required to issue notice of the audit to all partners, each of whom had the right to participate in the audit or judicial proceedings and to negotiate a settlement directly with the IRS. An audit ended when the IRS mailed to the TMP and to each partner who had not settled with the IRS a notice of Final Partnership Administrative Adjustment (FPAA). Partners could challenge the IRS’s findings in court, even if the TMP chose not to do so. The IRS had one year after the issuance of the FPAA to audit and collect taxes from the various partners.
Under the new rules, the IRS can audit partnerships at the entity level and require the entity to pay the imputed underpayment, which is determined using the highest individual or corporate rate of tax. Upon completion of the audit, the IRS will send a “notice of proposed partnership adjustment,” after which the entity will have 270 days to seek adjustments. Upon receipt of the final audit adjustment notice, the entity will have 45 days to elect out of the entity-level tax and 90 days to petition for a readjustment. To elect out of the entity-level tax, the entity must furnish each partner with a statement of the partner’s share of the adjustment, and the partners will be responsible for paying their respective shares of the assessed tax. If the entity makes this election, interest on the imputed underpayment increases from 3% to 5%. The entity owners will be bound by the adjustments shown on the statements they receive; there is no provision for administrative or judicial recourse for partners. In addition to changing the procedure for audits of partnerships, the new rules also change how the entities are represented in the audit process. The TMP is replaced by the “partnership representative” (PR). Whereas the TMP had to be an owner of the entity it represented, the PR need not be, though he, she, or it must have a “substantial presence” in the United States. If the PR is an entity, there must be a designated individual through whom the PR will act. Perhaps most importantly, while the TMP could bind the partnership, it could not bind any partner with regard to audit results. The PR, however, has sole authority to bind the partnership. The partnership and all of its partners will be bound by the decisions the PR makes in the audit proceedings. If an entity failed to designate a TMP for a particular year, that role would fall to the partner with the largest profits interest at the close of the taxable year. If an entity fails to designate a PR, the IRS may select “any person” to fill the vacancy.
Certain entities will be able to opt out of the new rules. Opting out is available if the entity has not more than 100 owners, each of whom is an “eligible partner.” An eligible partner is an individual, a C corporation, an S corporation, an estate of a decedent, and certain foreign entities. If any owner of an entity is a disregarded entity, a partnership, a limited liability company, a trust, or an ineligible foreign entity, it cannot opt out of the new rules. If an entity is able to opt out, it must make an annual election to do so and must provide the name, tax identification number, and tax classification of each owner. The partnership must notify each partner of the election within 30 days. If an entity is eligible to opt out and properly elects to do so, the IRS cannot audit the entity in a unified proceeding. Instead, it must initiate audits of each partner and will be able to collect the assessed tax from such partners.
In light of the new audit rules, partnerships, limited liability companies, and S corporations should consider revisiting their governing documents. Such entities will want to make sure that their governing documents address, for example, how the PR is chosen and provide that the entity have a PR at all times. Partners may want to require in the governing documents that the PR give all partners notice of an audit and should consider whether the PR must put audit matters to a vote of the partnership. In addition, because an audit assessment may relate to a prior year in which ownership of the partnership was different, governing documents should require all partners to be liable for audit assessments for their years of ownership, even after they have left the partnership.