The New Centralized Partnership Audit RegimeJanuary 4, 2019
As previously advised by our Real Estate Group, 2018 partnership returns will be subject to a new IRS audit regime. In general, all partnerships (domestic and foreign, including those with 10 or fewer partners) required to file a U.S. Federal income tax return are now subject to the new centralized partnership audit regime for tax years beginning after December 31, 2017, unless the partnership is eligible to elect out and makes a timely election to do so. A key feature of the new regime is that the tax is collected from the partnership rather than the partners. Alternatives are available to shift the payment burden to the partners, as discussed below.
A significant number of partnerships that were previously exempt from the audit rules of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) will now be subject to the new regime. The IRS issued final regulations during 2018, and it is important that partners, partnerships and their advisors be aware of the rules contained in the new regime regarding the way partnerships are audited and how any resulting tax liability is computed, assessed and collected.
The new regime generally imposes a partnership-level obligation for amounts due as a result of any IRS audit adjustments. The increase in tax now becomes an obligation of the partnership in the year the taxes are finally determined (the “adjustment year”) rather than of those that were partners in the year under audit (the “reviewed year”). The now-repealed TEFRA rules did not contain a statutory mechanism for collecting tax at the partnership level and required the IRS generally to pursue payment of underpaid tax directly from the partners.
Electing Out of the New Regime
Certain partnerships may elect out of the new regime. The election must be made annually on a timely filed return, including extensions, for the tax year to which the election applies and, once made, is irrevocable for that year. This should be kept in mind when preparing 2018 partnership tax returns. In order to elect out of the new regime, a partnership must be an eligible partnership. To be an eligible partnership it must have 100 or fewer partners, and all partners must be considered eligible partners at all times during the tax year. Partnerships with S-corporation partners must include the number of S-corporation shareholders in determining whether the partnership has 100 or fewer partners.
An eligible partner is any person who is an individual, C-corporation, eligible foreign entity, S-corporation or estate of a deceased partner. An S-corporation is an eligible partner regardless of whether one or more shareholders of the S-corporation is not an eligible partner. Eligible partners do not include partnerships, trusts, a foreign entity that is not an eligible foreign entity, a disregarded entity or an estate of an individual other than a deceased partner or a nominee.
A partnership making an election to opt-out of the new regime must also disclose to the IRS certain information about each person who was a partner at any time during the tax year of the election. Finally, a partnership that makes an election to opt-out of the new regime must notify each of its partners of the election within 30 days of making the election.
The Partnership Representative
The new regime now requires every partnership to designate a partnership representative (PR). The PR fills a role that is similar to that of the previous Tax Matters Partner (TMP) under TEFRA, but with significant differences. Once designated, the PR will remain in that position until the PR resigns, the PR’s designation is revoked or the IRS determines the designation is no longer in effect. Any person or entity with substantial presence in the U.S. may be designated as a PR. Substantial presence exists if the designated person makes themselves available to meet in person with the IRS in the U.S. and has a U.S. tax identification number, domestic street address and telephone number. A separate PR designation is made each year on the partnership’s tax return for the taxable year, and the designation is only effective for that year. A partnership may designate itself as its PR, and in cases where the partnership does designate itself or an entity as the PR, it must also appoint a designated individual who also has a substantial presence in the U.S. to act on the entity’s behalf. The new regime also provides rules concerning when, and under what circumstances, a PR may resign or have its designation revoked and the procedures for designating a successor PR.
The new regime gives the PR complete powers to represent the partnership in most circumstances before the IRS, and the actions of the PR are binding on the partnership and the partners for any matter covered by the new regime. Even if the PR’s designation is terminated, any actions taken prior to the termination date remain binding on the partnership. Additionally, except for a partner that is the PR, no other partner or person may participate in an administrative proceeding with the IRS, although the PR can still appoint a third party (such as a CPA or attorney) to represent the partnership before the IRS through a properly executed power of attorney.
Alternatively, in lieu of collecting the tax from the partnership, the partnership can elect to “push out” any adjustments to its reviewed-year partners. Under the push-out election, the reviewed-year partners must take the adjustments into account at the partner level and report the adjustments on their tax returns for the year in which the push-out election is made, not the reviewed year. The election must be made within 45 days of the date the final IRS adjustment is mailed to the partnership, be signed by the partnership representative and filed with the IRS. The partnership must also furnish separate information statements to the reviewed-year partners informing them of the adjustments and then file those statements with the IRS. Once the partnership makes the push-out election, the partners are bound by the election, and once the election is made for a given adjustment, it can only be revoked with the consent of the IRS.
Under this procedure, the partnership effectively shifts the audit liability to reviewed-year partners rather than the adjustment-year partners without making a push-out election. Within 270 days of receipt of the IRS adjustment, in lieu of actually filing an amended return, a reviewed-year partner pays his share of the partnership’s tax, and then the partnership demonstrates to the IRS that some or all of the reviewed-year partners have been deemed to have amended their reviewed-year tax returns to reflect their share of the audit adjustments and have paid any resulting tax.
The replacement of the TEFRA rules with the new regime presents numerous challenges, and new reporting requirements for partnerships and their partners and eligible partnerships will have to decide whether they want to elect out of the new regime. Additional consideration should be given to who is appointed PR. Before filing their 2018 partnership tax returns, partnerships and their partners should seek advice from their professional tax advisors in understanding and analyzing the consequences of these new audit provisions and elections.