Most partnerships and limited liability companies taxed as partnerships (collectively, “partnerships”) are now in the middle of preparing their 2018 tax returns. They may notice a new line on their tax returns where they designate a “partnership representative.” The partnership representative replaces the former “tax matters partner” role that was applicable for tax years prior to 2018. The change is much more than just a title change, though: the new name brings along with it a new set of IRS audit rules for partnerships which were designed to make it much easier for the IRS to audit partnerships and collect tax on any underpayments.
Any partnership audit under the new rules will now be conducted solely at the partnership level, with the IRS dealing solely with the designated partnership representative. If the IRS determines that the partnership underreported its income for the year, the IRS will now collect any tax on this underreported income from the partnership. The additional tax will be calculated using the highest marginal tax rate for the year: 37% for 2018. Under the old audit rules, any proposed underpayment of tax flowed through to the partners, requiring the IRS to collect the tax from the partners and allowing the partners to use their own income tax deductions, losses, credits, and marginal tax rates to potentially lessen the overall tax burden.
Under the new audit rules, a partnership may request a modification of any proposed underpayment by the IRS, but the onus is on the partnership to prove that the actual tax due should be lower as a result of various factors, including partners subject to lower tax rates and partners that may be tax exempt. If the partnership, through the partnership representative, does not make a timely modification request that attaches all of the relevant information the IRS would need to grant a modification request, the partnership will be required to pay the full amount due as calculated by the IRS.
Once the IRS finalizes the total underpayment amount, partnerships may either pay the underpayment amount directly, or they may elect to pass this amount through to their partners. This election must be made within 45 days of the final adjustment by the IRS. This so-called “push-out” election has no effect on the final underpayment amount.
Certain partnerships may elect out of these new partnership audit rules each year. A partnership may generally elect out if (1) it has 100 or fewer partners during the taxable year, and (2) each partner is an individual, a C Corporation, an S Corporation, or an estate of a deceased partner. In the case of an S Corporation, each S Corporation shareholder counts toward the 100 partner limit. If the partnership has another partnership or a trust as a partner, it cannot elect out of these new partnership audit rules.
Partnerships should update their partnership agreements to address these new audit rules. In particular, partnership agreements should address at least the following issues:
- The obligations of each partner to provide the partnership representative in a timely fashion with any information necessary to make elections with the IRS and/or request a modification of a proposed underpayment;
- The obligations of former partners to reimburse the partnership for an underpayment amount during a tax year in which they were partners; and
- The selection of the partnership representative, who will have complete and sole authority to make elections, requests, and otherwise deal with the IRS in the audit process.