The 2015 Tax Act had a provision changing the way the IRS has audited partnerships under a law going back to the 1980s. The new provision became effective January 1, 2018, so it now applies to partnership returns being filed this year.
Partnerships, or entities that file partnership tax returns like certain limited liability companies, are usually thought of as “flow-through” entities that pass all income and deductions to their owners to report and pay the tax. This meant that the IRS under procedural law had to audit and collect additional tax from each partner rather than going directly to the partnership generating the taxable income. Because of their flexible nature, partnerships became the entity of choice for tax shelters. Requiring the IRS to audit each partner in a tax shelter proved burdensome, so in 1982, the Tax Equity and Fiscal Responsibility Act of 1982 or “TEFRA” was passed and allowed the IRS to audit certain partnerships directly. The problem for the IRS with this law was that even though they could audit the partnership, they still had to collect from each individual partner. Partners could be other partnerships with other partners, foreign entities, people in other states, etc., so the process was still burdensome for the government.
So, because of these burdens in collecting, the IRS went back to Congress for additional relief and finally got it. The 2015 Tax Act allows the IRS to both audit and collect from partnerships directly. The procedure on how the IRS will do this, has been debated and changed several times and will probably be changed several more times since the law was first passed.
It helps me to think of a flowchart in applying the law. The first decision box is to decide if the law even applies to the partnership. Where the old TEFRA partnership rules applied to all partnerships that had more than 10 partners, the 2015 Tax Act only applies to partnerships that have more than 100 Eligible Partners. The IRS has published regulations on what is and is not an ineligible partner. Human beings are eligible partners for example, but foreign companies, and other partnerships are not eligible partners. If a partnership has a single ineligible partner, it will not be able to elect out of the new partnership audit rules.
The 2nd decision box is if the partnership does meet the Less-Than-100-Eligible-Partners test. If the partnership meets this test on an annual basis, it can elect out of the new audit rules. This is usually the best thing for taxpayers. This means that the IRS must audit each individual partner within the statute of limitations and collect from each partner. Government resources tend to be scarce and the easiest way to solve a problem is to avoid it.
If the partnership has more than 100 eligible partners, any ineligible partner, or simply fails to elect out of the new audit procedures on its tax return, then it is subject to the new audit procedures. Under these audit procedures, the partnership’s Tax Matters Representative controls the audit. Any changes to the tax return for the partnership is billed to the partnership. There are complicated rules on how the partnership reports this to its partners. Alternatively, the partnership can elect to “push-out” the adjustment within 45 days of receiving the Final Partnership Administrative Adjustment notice. If the Push-Out election is made by the partnership, then the partner’s share of income adjustment is automatically assessed and billed to the partner with no right to contest it. This election shifts the economic burden for actually paying any tax due from the partnership to the partners. While this option would seem to defeat the purpose of the new audit rules and allowing the IRS to collect from partnerships, the new rules allow the IRS to charge more interest on a Push-Out election
As a practical matter, we tend to like revocable trusts to hold partnership interests. These entities are normally disregarded for tax purposes and allow clients to avoid probate. However, under the current version of the audit guidelines, these revocable trusts are ineligible partners, so electing out of the new partnership audit rules will not be an option for people using these trusts to avoid probate. Since death is certain and partnership audits are far less than certain, being subject to the new audit rules is probably the lesser of 2 evils. People may also want to review their partnership agreements and think who they would like to bind the partnership in the event of an audit.