By Jennifer Youngblood | November 28, 2016 |
On Nov. 2, 2015, President Barack Obama signed into law the Bipartisan Budget Act of 2015 (BBA). While the main purpose of this legislation was to re-allocate funds to ensure disability recipients will receive benefits through 2022, it also included new rules related to audits of partnership information returns.
A partnership is a separate legal entity that is owned by two or more partners. A partnership is a flow-through entity, meaning it does not pay taxes on the net profits it realizes. Instead, the partners are allocated their respective share of the partnership’s profits (or losses), and pay the related income taxes on their income tax returns at their marginal tax rate.
It is not uncommon for the IRS to select taxpayers for audit. However, historically, partnership returns are rarely selected because of the complexity involved in collecting the tax assessed from the partners. The BBA outlines the “new partnership audit rules,” which are new rules under which partnerships will be audited, and the new process for collecting the additional tax assessment.
The new partnership audit rules – effective Jan. 1, 2018, with an immediate opt-in election available – state that any additional assessment of taxes upon completion of the audit of a partnership will be imposed on the partnership, not the partners. In addition, the tax will be calculated at the highest individual marginal tax rate at 39.6 percent, along with assessment of penalties and interest on the tax or taxes due. During the audit process, the IRS will work with a partnership representative who:
- Has authority to bind the partners;
- Is not required to be a partner; and,
- Has sole authority to act on behalf of the partnership.
The partnership can elect to opt-out of these rules, and is performed annually when filing the partnership return. This election to opt-out is only available to partnerships that meet the following requirements:
- Is considered a small partnership; (i.e., issues 100 or fewer Schedule K-1s)
- Partners consist of individuals, C Corporations, foreign entities treated as C Corporations, S Corporations, or an estate of a deceased partner.
- Note – if your partnership has a partner who is a trust, you are not eligible to opt-out!
If the partnership elects to opt-out of the new partnership rules, it will issue revised information in the form a substitute Schedule K-1 to all partners to reflect their share of the audit adjustments. The IRS also receives a copy of this information from the partnership.
As a result of these new rules, it is expected the number of partnership audits will increase, placing an added burden on the partnership and its representative. A new partner in a partnership could be liable for taxes due from the prior year that comes under audit. Therefore, a review of existing partnership agreements should be executed, and consider whether to amend the partnership agreement to include language regarding the collection of tax from subsequent new partners. It is anticipated the IRS will issue proposed regulations by the end of 2016.
Maddox Thomson is available, as always, to advise our clients on what these changes mean for your partnership.