Authored by Paul Dillon, Mark Heroux, Michelle Hobbs and Michael Wronsky
During 2017 the IRS issued regulations pertaining to the audits of partnership returns. These regulations are binding on partnerships effective for partnership tax years that begin after Dec. 31, 2017. The new regulations require changes to every partnership agreement. Partnerships are well advised to review and change their partnership agreements in accordance with the requirements of the new guidelines. The regulations also may affect partnerships’ financial statements as they can now potentially have deferred tax exposure under ASC 740.
The new regulations create a partnership tax liability
A partnership is a flow-through entity that is not subject to federal income taxes — until now. The new regulations dictate that any additional federal income taxes that arise as a result of an IRS exam will be assessed against and collected from the partnership. The assessment will be made in the year that the adjustment is made (the adjustment year) and is payable with the filing of the partnership’s Form 1065, U.S. Return of Partnership Income, for the adjustment year. In other words, if the IRS audits a partnership’s 2018 tax return in 2020, that tax will be due with the partnership’s 2020 return.
The new regulations provide a complex system of rules that allow the partnership to push out the assessed liability to partners of the partnership during the year under review by the IRS (the reviewed year) or to have the assessed liability allocated to partners of the partnership in the adjustment year. But unless the partnership can elect out of the new regime, there will be a tax assessment against what has heretofore been a nontaxable entity. Taxpayer-favorable adjustments do not produce a refund to the partnership but are reported as Schedule K-1 adjustments to adjustment-year partners. However, partners during the review year may likely argue the favorable adjustments should be reported to them. The partnership agreement needs to provide certainty here, which will likely require an amendment since this issue has never needed to be addressed before.
The new regulations apply to all partnerships
Partnerships that issue 100 or fewer Schedules K-1 that do not have any partnership (tiered partnership structure) or trust partners can elect out of the new regime, in which case, the IRS exam will take place at the partner level. Partnerships elect out by making an annual election on a timely filed Form 1065. Partnerships with partnership or trust partners will want to review their structure to see whether a restructuring can position the partnership to elect out of the new regime.
The partnership representative
The new partnership audit regulations require partnerships to identify a partnership representative. This is different than the previous tax matters partner. The partnership representative has sole authority to act on the behalf of the partnership. The partnership representative controls the IRS exam, decides whether and when to extend the statute of limitations, whether to accept a settlement, and whether to agree to an adjustment. In short, every major decision related to an IRS exam is made by the partnership representative. Consultation with any of the partners is not required by statute or the new regulations. The partnership representative must raise penalty defenses regardless of whether the defense relates to the partner or the partnership. The partnership representative may be a firm. If the partnership agreement does not identify a partnership representative:
- the IRS can appoint a partnership representative for the partnership; and
- the IRS’ appointment is not a reviewable decision.
Partnerships are well advised to identify a partnership representative in their operating agreements or to provide a process in the partnership agreement for appointing the partnership representative. The appointment should not be left to the IRS.
Planning consideration: Consider putting limitations on the acts of the partnership representative, e.g., the partnership representative cannot accept a settlement offer without first obtaining the approval of 60 percent of the partners. The partnership representative is identified in the annually filed Form 1065.
Planning consideration: Consider having the partners form another entity to act as the partnership representative in case of an audit. This could provide partners’ input into the decision of the partnership representative.
ASC 740 implications
The new partnership audit regulations will require partnerships conduct an ASC 740 review of their transactions. Going forward, partnerships will need to analyze their tax positions to see if they meet the more-likely-than-not standard and potentially record a deferred liability for — and identify in the income tax disclosure — positions that do not meet this standard. This will be a significant change from just including a disclosure that partnerships pass through their liabilities to their owners. Even if the transaction meets the more-likely-than-not standard, the posting of a reserve may still be necessary because ASC 740 imposes limitations on the largest amount of the benefit a taxpayer can report on transactions that meet the more-likely-than-not standard. Consequently, a reserve and related disclosure may still be required for transactions that meet the more-likely-than-not standard. This is a seismic change for partnership financial statement audits.
Planning consideration: For partnerships with financial statement implications, begin planning for your disclosures now by identifying positions that could give rise to disclosures under ASC 740. The required analysis can be extensive and complex and should be addressed accordingly when planning financial statement audit or review engagements.
Partnerships should consider the changes imposed by the new audit regulations and review and make changes to operating and other agreements before the start of 2018. Do not wait until December to get your partnership agreements modified. Let all partners know the rules of the game that apply beginning Jan. 1, 2018.
For more information on this topic, or to learn how Baker Tilly specialists can help, contact our team.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.