Re-issued Partnership Audit Regulations will Impact Your Partnership Agreement
The Bipartisan Budget Act of 2015 introduced a new role to the world of partnership taxation called the “partnership representative.” The duties and powers of the partnership representative were defined in proposed regulations prior to the changeover to the Trump administration, but these were blocked for a time under a post-election review requirement. Subsequently, Congress considered a technical corrections bill that would address a number of mechanical issues under the law, and on June 13 of this year the Treasury Department released, in essentially identical form, the previously blocked proposed regulations. While the proposed technical corrections bill, like the proposed regulations, does not presently have the force of law, they should be taken seriously by partners in partnerships and by persons tasked with the tax management of such partnerships.
The new partnership audit regulations replace the former “TEFRA” partnership audit procedures that had been in place since 1982, and apply to partnerships for partnership tax years that begin after December 31, 2017. Because of the broad reach of the new regulations and the new partnership representative role, partnership agreements should be examined and modified to become compliant with the new requirements.
Do the New Partnership Audit Regulations Create a Tax Liability at the Partnership Level?
Unlike the TEFRA partnership audit rules, under the new regulations, and unless the partnership is able to “elect out,” any tax adjustments arising under an IRS exam will become partnership liabilities, such that the partnership will be charged with the additional tax in the “adjustment year.” If the partnership is able to elect out, the assessed tax liability can be allocated to the partners in the partnership during the year under audit, (known as the “reviewed year,”) or to the partners in the partnership in the adjustment year. However, unless the partnership explicitly elects out of the new rules, the tax audit assessment will be made against the partnership in the reviewed year.
The Role of the Partnership Representative
The partnership representative’s role is different than that of the tax matters partner (TMP) under the former TEFRA audit regulations, in that the partnership representative is the only person authorized to represent the partnership in an IRS audit and to make audit-related decisions on its behalf. The most obvious difference between the role of the TMP and that of the partnership representative is that, unlike the TMP, the partnership representative doesn’t need to be a partner in the partnership. In fact, the partnership may prefer the partnership representative not to be a partner in order to avoid potential conflicts of interest.
The partnership representative isn’t obliged to obtain input or consent from the partners in his or her role. In fact, unless the partnership agreement names the partnership representative annually on its timely filed partnership tax return, the IRS can appoint a partnership representative for the partnership. To avoid this situation, the partnership agreement should be updated to identify a partnership representative. The partners may choose to limit the authority of the partnership representative at that time. One way to do this might be to have the partners create a legal entity that they own and that acts as the partnership representative, so that the owners’ preferences can be taken into account. However, note that the new rules require the entity to appoint a “designated individual”—a natural person -- to be “the sole individual through whom the partnership representative will act for all purposes under subchapter C of chapter 63.” If a partnership designates an entity as the partnership representative but fails to name a designated individual, the IRS may simply disregard the entity’s designation. Limiting the role of the partnership representative through the partnership agreement might include requirements to provide the partners with timely information regarding significant IRS communications; obtaining the approval of partners for audit-related actions; defending against tax audits; or requiring an election to push out a tax adjustment to reviewed year partners. Otherwise, the partners’ only recourse against the partnership representative would be a legal action.
Electing Out Under the New Rules
As stated above, taxes arising under an audit are charged to the partnership in the adjustment year, but the new rules allow the partnership to allocate the entire tax adjustment arising from the assessment year to partners in the reviewed year, by making an election no later than 45 days after the date the IRS advises the partnership of the partnership tax adjustment. At that time, the partnership must provide the IRS and every partner in the reviewed year with a statement regarding the reviewed year partner’s share of the tax adjustment. That tax adjustment is then reflected on the reviewed year partners’ tax returns for the adjustment year. Because the partners in the adjustment year and the reviewed year may not be identical, the partnership agreement should identify clearly the partners who will be liable for IRS taxes under audits. This may involve escrow arrangements so that partners that were not partners in the reviewed year are not subject to liability for future IRS tax adjustments.
Because of the effective date of the new rules, partnerships should take up the task of updating their partnership agreements. In order to be effective with respect to calendar year partnerships for the 2018 calendar year, any amendments to the agreement should be completed before March 15, 2019, the due date for 2018 calendar year partnership returns (without extension.) FGMK’s tax practice can assist you in evaluating the potential impact of the new partnership audit rules and in reflecting these in an amended partnership agreement.
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