Thanks to the Bipartisan Budget Act of 2015, the Tax Equity and Fiscal Responsibility Act (TEFRA) partnership audit rules have been replaced with a new set of procedures. The change is generally effective for tax years beginning after Dec. 31, 2017, but partnerships may apply the new procedures earlier or, under certain conditions, elect out of them altogether.
Generally speaking, the new federal rules require adjustment of all items of income, gain, loss, deduction or credit to happen at the partnership level. This makes the partnership liable for any resulting underpayment of tax. The new rules also tax the adjustments at the highest individual or corporate tax rate.
It’s time to explore your options: Is it best for your partnership to apply the rules early, wait for the effective date, or elect to opt out?
How could the new rules benefit my partnership?
It really boils down to one word: Simplicity. The new rules could make your tax filings much less complicated if the following are true:
- All of your partners are high-income taxpayers who don’t want to deal with the administrative burden of amending their individual tax returns.
- Your partners don’t mind having the partnership take care of paying the tax.
- Your partners have been partners in the partnership for a long time and its makeup has not changed.
- All of your partners agree to bear the same economic burden.
Why would my partnership want to elect out?
Under the new rules, any federal tax adjustments (assuming you have adjustments, that is) will be taxed at the highest individual tax rate of 39.6 percent. Previously, any adjustments would have been passed down to the individual partners; each would have been taxed within the appropriate partner’s tax bracket. Some potentially would have been taxed at 10 percent, others perhaps at 39.6 percent. It’s not equitable for partners who qualify for lower tax brackets to be hit with the highest level of tax.
What’s more, under the new rules each partnership must designate a “partnership representative.” This person has the sole authority to act on behalf of the partnership. The other partners are not required to be notified of any potential changes and are bound by the actions of the representative.
When the tax is passed down to the partnership, the partners in the partnership for the current year are effectively required to pay it. This means that a prior year audit could affect current partners, even if they weren’t around during the year in question. Newer partners could most certainly lose out.
Finally, it is unclear how the various states will apply the new federal partnership audit adjustment rules unless the partnership elects out. This may further complicate applying the new federal rules.
The bottom line: Fairness for the individual partners is not a hallmark of the new rules.
Can my partnership elect out?
Only partnerships that are required to issue no more than 100 Schedules K-1 and are comprised solely of individuals, estates of a deceased partner, S corporations or C corporations can elect to opt out.
Partnerships that are comprised of other partnerships are not eligible to make the election and must comply with the new rules.
It’s also important to note that if you don’t make an election to opt out, your partnership will automatically be subjected to the new rules as soon as they take effect. The election is made annually which gives partnerships the ability to decide each year which option is best for them.
What should we do now?
Regardless of whether you decide to accept the new procedures or opt out of them, you will need to consider revisions to your partnership agreement and should consult with a partnership attorney. If you’re unsure of how the rules may affect your partnership, DS+B can help. Please contact me with your questions.
It’s likely the IRS will more aggressively pursue partnership audits now that they will be easier for its agents to make adjustments that require less work by the agent. Make sure your partnership is prepared to comply in whatever course of action you choose.