After years of discussion and numerous proposals, last October Congress finally repealed the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) partnership audit rules and replaced them with an entirely new audit, assessment, and collection regime. Over time, the TEFRA rules had become unworkable, resulting in very few partnership audits. The growth of tiered partnership structures had made it virtually impossible for the IRS to track and collect the additional assessments from each individual partner. The changes are widely expected to dramatically increase the audit rates for partnerships and will require revisions to virtually every partnership’s operating agreement.
Application of the new rules
The new regime will generally apply to audits of returns filed for tax year 2018 and later. Small partnerships, now defined as those with 100 or fewer specified categories of partners, may opt out of the new rules on their original return. To be eligible for the opt-out, all of the partners must be individuals, C corporations, S corporations, or the estate of a deceased partner. For S corporations, each owner is counted as a single partner. Partnerships who choose to opt out will be subject to the old pre-TEFRA rules with assessment and collection of additional tax due at the partner level. We expect to see regulations detailing the procedures for the opt-out later this year, including notice requirements to the IRS and affected partners.
For all other partnerships, audits will be conducted and any adjustments will be made at the partnership level. There will be a single statute of limitations for assessment, also applied at the partnership level.
New terms to review
There are four key terms included in the legislation that you’ll need to learn in order to fully understand how the new regime will operate.
- Reviewed year: The tax year that is being audited.
- Adjustment year: The year during which the audit assessment is made final, generally through the issuance of a notice of final partnership adjustment or a court decision.
- Imputed underpayment: The amount of additional tax due, calculated by netting the audit changes and multiplying by the highest individual or corporate rate in effect during the reviewed year, currently 39.6%.
- Partnership representative: The replacement for TEFRA’s tax matters partner.
Partnership representative is key
The partnership representative will be central to the new regime. First, this individual or entity is no longer required to be a partner. They will act as the single point of contact between the IRS and the partnership with full authority to bind the partnership and the partners to the audit results. They will also be the person responsible for making the various elections and opt-outs available to the partnership. The current notice and challenge rules applicable to partners will no longer be in effect.
Current partners could be responsible for tax liabilities of prior partners
Under the new default procedures, the partnership will be required to pay any imputed underpayment directly to the IRS, along with interest and penalties. This means the adjustment-year partners will bear the burden of the payment, even if they were not partners during the reviewed year.
Two new methods could reduce the amount of payments
There will be two methods available to the partnership that can reduce the amount of the payment. First, the partnership may show that a reviewed-year partner has filed an amended return and taken their share of the adjustments into account by paying the appropriate additional tax. Second, the partnership may prove to the IRS that some portion of the adjustment is applicable to a tax-exempt partner, a C Corporation partner, or would represent capital gain to an individual partner. After the assessment is made final, the partnership representative will have 270 days to provide the IRS with the required proof for both methods.
Partnership may opt to issue adjustment K-1s
Under an alternate procedure, the partnership may opt to issue adjustment K-1s to the reviewed-year partners. This election must occur no later than 45 days after the final assessment. The partners will have to recalculate their tax liability for the reviewed year and all intervening years using a “simplified” amended return process. The additional tax, plus penalties and interest, will be paid with their adjustment year return.
We anticipate detailed IRS guidance on how the adjustment K-1s and simplified amended procedure will work sometime later this year.
Questions remain, but it’s advisable to consult with clients today
There remain many unanswered questions on how this new regime will operate, particularly when applied to tiered partnership structures. How states will conform to these new rules is also unclear. We understand that the Multi-State Tax Commission is considering a project to address that question.
As you meet with your partnership clients this filing season, you should ensure that they are aware of the upcoming new audit procedures and encourage them to contact their legal advisor about the need to modify their partnership agreements appropriately.
AICPA continues to work for you and offers resources to help navigate these rules
One significant change from the original proposals, and likely due to concerns raised by the AICPA, was the removal of a provision imposing joint and several liability on the partnership, the reviewed-year partners, and the adjustment-year partners for any imputed underpayment.
This article covers only a portion of the detailed technical provisions enacted to replace TEFRA. For more information, listen to the archive of our January Washington Tax Brief, and read our article from The Tax Adviser: Congress Changes Partnership Audit Procedures.
The AICPA’s Tax Division will be working with the IRS as they develop the necessary forms, procedures, and regulations for implementation. We also will be developing additional tools and resources to help you guide your clients through these new audit procedures.
Please utilize our recently added resource:Letter to Advise Client on Partnership Audit Changes. Also, consider attending our webcast in May on the topic (the registration link will be posted soon on our CPE & Learning page).