The Bipartisan Budget Act of 2015 introduced new partnership audit rules that took effect this year. Partnerships — including LLCs taxed as partnerships — should pay close attention to these rules. You might assume that audit rules are merely procedural, but the new rules make significant substantive changes, essentially subjecting partnerships to entity-level taxes for the first time.
In a dramatic departure from prior practice, the new rules permit the IRS to collect taxes from partnerships rather than from individual partners. By reducing the administrative burdens associated with partnership audits, the new rules will likely increase the number of audits. In addition, in many cases, application of the new rules will increase partnership tax liabilities. Why? Because the IRS will determine additional taxes by multiplying the net adjustment by the highest marginal individual or corporate tax rate for the year being audited (the “audit year”). The partnership must account for the resulting “imputed underpayment” in the adjustment year.
By imposing tax at the highest marginal rate, partners will lose the benefit of tax-exemptions, lower tax rates, or other partner-level tax attributes that would otherwise reduce their tax liability. However, partnerships will be able to reduce their imputed underpayments by providing the information necessary to establish these tax attributes.
Another burden imposed by the new rules: Since additional taxes are accounted for in the adjustment year, in some cases current partners will be held liable for tax errors that benefited former partners. Partnerships will have two options for avoiding this result:
- Arrange for audit-year partners to file amended returns reporting their distributive shares of partnership adjustments and pay the tax within 270 days; or
- File an election, within 45 days after the audit, to provide audit-year partners with adjusted information returns that will be reflected in their adjustment-year returns.
The new rules allow certain smaller partnerships to opt out in exchange for assuming additional reporting and disclosure obligations.
The IRS has issued both proposed and final regulations interpreting and clarifying the operation of the new rules. Partnerships should work with their tax advisors to evaluate the potential impact of the new rules and discuss strategies for avoiding harsh consequences.