Partnership Audit Changes Will Impact Pass-Through Investors Starting In 2018

Post By Richard Ruvelson

The Bipartisan Budget Act of 2015, (“the BBA”), which was enacted into law on November 2, 2015, repeals the current rules, enacted by Congress in 1982, governing partnership audits and replaces them with a new centralized partnership (includes LLCs taxed as partnerships) audit regime that, in general, assesses and collects tax, interest and penalties at the partnership level. This change can turn pass-through investments into income tax taxpaying entities. Under Temporary Regulations, issued in August of 2016, if there are adjustments resulting in additional, tax (computed at the highest corporate or individual rate, whichever is applicable), interest and penalties (an imputed underpayment), the partnership must pay the “imputed underpayment”, unless it elects to have partners for the year audited pay the “imputed underpayment.”

The “imputed underpayment” may be reduced if the partnership establishes any of the following:

  • A portion of the underpayment is allocated to a tax-exempt or qualified plan partner that would not have paid tax on the item(s) changed.
  • A portion of the item(s) changed would be allocated based upon the type of taxpayer and the types of income being allocated and allocations of particular partnership items, or partners file amended returns for the year audited.

Alternatively, partnerships may elect to pass on the “imputed underpayment” to partners who were partners in the years audited, and the partners must take into account the amount owed on their tax returns in the year of the adjustment.

The repeal of the partnership audit rules enacted in 1982 and implementation of the new partnership audit rules are generally effective for partnership taxable years beginning after December 31, 2017. However the law and The Temporary Regulations provide that a partnership may elect for parts of the new law to apply to partnership taxable years beginning after November 2, 2015 and before January 1, 2018. The Temporary Regulations provide that partnerships selected for audit by the IRS, for taxable years beginning after November 2, 2015 and before January 1, 2018, may elect to have the new rules apply to the audited years and, also, provide a mechanism for partnerships not under audit to, also, elect to have the new rules apply if they are subsequently chosen for audit of the same years.

Once the new rules become effective, it will be possible for a partnership to elect out of the application of the centralized audit rules on an annual basis, if for a particular year the partnership issues 100 or fewer Schedule K-1s for the year; each of the partners is an individual , a “C” Corporation, any foreign entity that would be treated as a “C” Corporation were it domestic, an “S” Corporation or an estate of a deceased partner; the election is made with a timely filed return and the partnership notifies each partner of the election.

When considering a partnership investment, potential partners should discuss the rules with prospective managers. For all investing businesses, it is now more important than it was previously that partnership records, including Forms K-1, properly reflect whether the partner is an individual or properly reflect the type of entity. Most importantly, understand the investment’s partnership agreement, the role of managers and notifications.

We are happy to assist you with acknowledgements and/or answer any questions that you have.

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