Small partnerships could be spared the toughest of the new IRS audit rules, or partners could take an alternative approach.
The Bipartisan Budget Act of 2015 changed the IRS partnership audit rules. These rules became effective January and could significantly shift audit adjustments to partners who may not have received the benefit, or paid tax, on an original tax assessment.
The BBA significantly changes how the IRS collects tax underpayments. Under the new rules, tax underpayments, including assessed interest and penalties, computed at the highest individual tax rate (with a few exceptions), will be collected directly from the partnership.
While the shift away from collecting tax from individual partners simplifies tax collection for the IRS, it also shifts the obligation to pay the tax, from the partners in the audited year, to the partners in the collection year. A new partner could indirectly be stuck with a large tax bill by way of a current year partnership tax assessment related to a period before ownership.
The new law allows for two elections:
- Section 6221 - The small partnership election
- Section 6226 - The alternative election.
The Small Partnership Election
The small partnership election allows a partnership to elect out of the new rules. For purposes of this section, a small partnership is defined as a partnership with 100 or fewer partners and no flow-through entity partners (other than S-corporations and estates of deceased partners). The partnership must not have any foreign partners (unless taxed as C-corporations under U.S. tax law).
The small partnership election is made annually on the partnership income tax return and includes a list of partner names and taxpayer identification numbers.
The Alternative Election
This election allows for tax to be levied on the audited year partners. The election must be made within 45 days from the date of the notice of final partnership adjustment. The partnership must issue a statement of the partner’s share of adjustment to income, gain, loss, deduction or credit to the IRS, and to each partner of the audited year. The income adjustments are then reported on each partner’s current income tax return.
For example, in January 2019, Joe purchases a 50 percent interest in BadBooks, LLC from Alphonse. BadBooks had reported a loss on the 2018 partnership return of $1million. Alphonse’s share of that loss was $500,000. The IRS selects the 2018 partnership return for audit, and after adjustments, the previous partnership loss turned into $200,000 of profit, an increase of $1.2 million. Under the new audit regime, BadBooks will pay $444,000 of federal income tax ($1,200,000 x 37%). The underpayment is taxed at the highest individual federal rate.Shirley, the BadBooks managing partner, did not make the small partnership election on the 2018 return and does not make an alternative election within 45 days after the notice of final partnership adjustment. The tax must be paid out of the assets of BadBooks.
If Shirley had made the small partnership election on the 2018 return, or if she had made a valid alternative election within the specified time, Alphonse would be required to pick up an additional $600,000 ($1,200,000 x 50%) of income on his current tax return. The failure to make either election cost Joe $222,000.
All existing partnerships should determine eligibility to elect out of the BBA audit regime, and if eligible, decide to make the election or abide under the new audit rules. If not eligible, could a change in partners accomplish eligibility?
For example, trusts (including grantor) are not eligible partners. If a partnership has a grantor trust as a partner, distribution of the LLC interest out of the trust to the owner would enable the partnership to elect out of the BBA audit regime. If the partners want to remain eligible, the partnership agreement could be amended to prohibit a transfer of interest to an ineligible party.
Ownership changes highlight the importance of making an election under this new tax law. A new partner will assume the liability of future tax assessments without either of the elections. Before buying a partnership interest of an existing partnership, all new partners should perform due diligence to determine if any tax surprises could arise.
While the effects of the BBA audit regime will not be felt until 2020, partnership agreements should be amended to consider all relevant elections. The new elections could have a financial impact on current and past partners.