Under the new audit rules, individual partners cannot participate in the partnership tax audit. Rather, one “partnership representative” acts on behalf of the partnership, and binds the partnership to any adjustments that are made. Under the new rules, partners no longer have the right to be notified of, or participate in, partnership tax audits.
Most importantly, the IRS will assess the tax at the highest individual tax rate (37% as of 1/1/2018), regardless of any individual partner’s marginal tax bracket.
Newly-defined “small partnerships” (that is, those with 100 or fewer partners, all of whom are “qualified” partners) may elect out of these new rules under an annual election made with a timely filed partnership tax return, under Code Section 6221.
The election must identify all partners by name and social security number or EIN (for example, for S corporation partners). The “electing-out” option needs to be incorporated in the partnership agreement (or, the operating agreement, for LLCs). In addition, all the partners in the partnership must be “qualified” for the election out to be permitted. Eligible partners include Individuasl; C corporations; S corporations (the S corporation counts as one eligible partner, and each shareholder counts as an eligible partner as well;) the estate of a deceased partner; and a foreign entity taxable as a C-corporation if it were domestic.
Certain partnerships that have the following partners are ineligible to elect out.
- Trusts, including grantor trusts;
- Foreign entities that are not eligible foreign entities;
- Disregarded entities;
- Nominees, other similar persons that hold an interest on behalf of another person; or
- Estates that are not estates of a deceased partner.
Electing Out, and the Amendment of the Partnership Agreement
The partnership agreement must provide the ability for the partners to elect out of the new audit rules, if they so desire. There are a number of issues to be addressed when amending the partnership agreement to account for this opt-out election.
- Is the option to be automatic as long as it is available, or it is one that should require annual approval by the partners?
- Alternatively, do the partners leave it to the partnership representative to determine whether the option should be elected?
- If the partners decide upon an annual election, should it be subject to an “evergreen clause” that requires affirmative election out of the option in a later year?
- If left to the partnership representative to decide, what factors should the partnership representative take into account?
- What liabilities apply to the partnership representative if the election is not made, but should have been made?
- What recourse do the partners have against the partnership representative if this is not defined in the partnership agreement?
- Does the partnership require the partners to file individual amended returns for any reviewed years and pay the taxes associated with any adjustments as finally determined, and if so, what liabilities arise if they fail to do so?
Ineligible Partnerships – The Push-Out Option
Partnerships not eligible for the “elect-out option” may obtain similar relief by “pushing out” the audit onto the partners in the year under review (not the year in which the review occurs).
- This election must be made by the partnership representative within 45 days after the date of the IRS’s Notice of Final Partnership Adjustment. There is an additional amount of interest (2%) on tax assessments for partnerships that make the push-out election.
- Note that the IRS will still collect the additional taxes and penalties from the partnership, thereby requiring the partners to consider beforehand including within the partnership agreement covenants requiring affected partners to pay the tax to the partnership, to then be remitted to the IRS.
- Note also that the affected partners have no right to appeal any of the proposed audit adjustments to the IRS, but instead must pay the tax and seek refund separately if they wish to contest the assessment.
- This “push-out” right raises several questions for the partners to consider within their partnership agreement (or operating agreement):
a. To what extent should authority be given to the partnership representative to make the push-out election?
b. Should it be mandatory in any case?
c. Should it be an election voted on by the partners?
d. What indemnification should be given to the partnership representative for his or her actions in electing the push-out option?
e. What notice requirements should be imposed upon the partnership representative to notify all affected partners (including former partners) of the partnership?
Because the new audit regime is applicable to all partnerships, all partnership agreements in existence prior to 2018 will need to be amended. For partnerships with many partners, this may present a perceived undue hardship. There appears to be some question as to who would be acting as the partnership representative where no amendment to an existing (pre-2018) partnership agreement is made, or where a group is found to be a partnership even though it never has “filed” as one (e.g., tenants in common).
Thus, whether or not a partnership qualifies to opt out of the new audit rules, all partnerships need to address this issue and revisit the partnership or operating agreement to ensure that all partners are equitably protected. If you would like any guidance regarding this matter, please do not hesitate to contact your FGMK tax advisor.
The summary information in this document is being provided for educational purposes only. Recipients may not rely on this summary other than for the purpose intended, and the contents should not be construed as accounting, tax, investment, or legal advice. We encourage any recipients to contact the authors for any inquiries regarding the contents. FGMK (and its related entities and partners) shall not be responsible for any loss incurred by any person that relies on this publication.