Is Your Partnership Ready for the IRS's New Centralized Audit Regime?
The new centralized audit regime for partnerships established by the Bipartisan Budget Act of 2015 (“BBA”) has been in effect since January 1, 2018, but is your partnership or LLC treated as a partnership for tax purposes equipped to handle an IRS exam under this new regime? More specifically has your partnership or operating agreement been updated or amended to account for this new centralized audit regime? The first batch of returns (calendar year 2018) subject to this new regime were filed by September 15, 2019. These returns were also the first batch of returns that included the information for the IRC § 199A Qualified Business Income Deduction. Based on these items, taxpayers should expect an increase in the number and frequency of partnership examinations in the near term.
Along with repealing the old partnership audit rules under the Tax Equity and Fiscal Responsibility Act (“TEFRA”) and those applicable to electing large partnerships, the BBA drastically changed the methodology employed by the IRS when examining partnerships. Under the new centralized audit regime the IRS determines adjustments and, in general, determines, assesses, and collects tax at the partnership level, not at the individual partner level, unless the partnership ‘opts out’ under the applicable provisions discussed below.
As evident from the litany of guidance that has been issued the IRS is preparing to use and implement these new procedures, despite the IRS having to simultaneously deal with overall tax reform implementation measures created by the enactment of the Tax Cuts and Jobs Act in December of 2017. Specific guidance issued concerning the centralized audit regime for partnerships includes, but is not limited to, Final Regulations (TD 9844) issued in February of 2019, multiple interim guidance memoranda for examiners issued in 2017, 2018, and 2019 until Internal Revenue Manual (“IRM”) pt. 4.31 is revised, multiple interim guidance memoranda for Appeals Officers issued in 2019 until IRM pt. 8.19 is revised, new tax forms, and other outreach to practitioners and taxpayers.
Given this, taxpayers need to: (1) know the audit risk for partnerships has increased; (2) be prepared for the new processes and procedures of the centralized audit regime; and (3) make certain that their operating agreements are updated to address the new centralized audit regime. The following is list of significant questions and concerns each and every partnership should consider and address in its partnership or operating agreement.
1. Can the partnership opt out of the centralized audit regime? Should it opt out if eligible? Does the existing partnership or operating agreement provide for opting out of the centralized audit regime?
By default, the centralized audit regime applies to all partnerships, however a partnership that furnishes 100 or fewer Schedules K-1 for the applicable tax year may elect to opt out of the regime provided that its partners are eligible partners - individuals, C corporations, foreign entities that would be treated as C corporations if they were domestic entities, S corporations, or the estate of a deceased partner. Partnerships with trusts, disregarded entities, nominees, ineligible foreign entities, estates, or other partnerships as partners may not elect to opt out. The opt-out election is an annual election made on the income tax return of the partnership.
Operating agreements should cover: (1) if the partnership even wants to opt out if eligible; and if so, (2) the mechanisms for making that determination, i.e., a vote by the partners each year well in advance of the deadline for filing the return.
If the partnership elects to opt out of the centralized audit regime, IRS audit, assessment, and collection proceedings, etc. are conducted at the partner level. Thus, the IRS will have to open a separate audit for each partner, and each partner will get to choose the administrative and litigation options available, which could lead to disparate results on the same issue and different settlements. Finally, partner level examinations will ultimately require cooperation from the partnership in terms of providing documentation and information to the IRS, therefore the operating agreement should include provisions requiring the partnership to cooperate in partner level examinations in a timely fashion.
2. Does the partnership or operating agreement provide for the selection of a Partnership Representative (“PR”)? Does the agreement articulate the limitations, obligations, and indemnifications of the PR?
Under the centralized audit regime and pursuant to the BBA, the PR makes all of the decisions on behalf of the partnership during the course of an examination and individual partners have no rights to participate in the exam in any way. In other words, the PR has exclusive authority to bind all of the partners to settlements, elections, extensions of statutes of limitation on assessment, etc. Bottom line, the selection of the PR and the modification of his or her authority through the operating agreement are critical aspects to ensuring readiness in the event of an exam under the centralized audit regime.
The designation of the partnership representative is generally made on the partnership return for each taxable year and is effective on the date the partnership return is filed. If the partnership does not designate a partnership representative, the IRS may select any person to act as the partnership representative. The partnership representative does not have to be a partner in the partnership, but must have a substantial US presence.
Operating agreements should place limitations on the PR’s authority, articulate the obligations of the PR to the partners, indemnify the PR for good faith actions, and contemplate the appointment and removal of the PR. For example, critical decisions like extending a statute, making elections, or settling an issue may require the PR to obtain the consent of a certain percentage of partners, or the partners may want to vote on these matters. In addition, the operating agreement may require the PR to notify the partners of various maters, like that an exam has commenced, the scope of the examination, etc. There are no statutory and regulatory requirements on the IRS to notify the partners of the partnership of an audit proceeding, the proposed adjustments, or the final resolution.
Finally, the PR will have broad decision making authority with the IRS, which may impact different partners in different ways, so some type of notice and indemnification provisions in the operating agreement for carrying out PR duties in good faith are likely warranted. Without the provisions in the agreement, the PR could handle and resolve an entire IRS audit without the partners’ knowledge or input.
3. Does the agreement place obligations on each partner to provide needed documentation and information to the PR in a timely manner to request a modification of a proposed imputed underpayment and/or make other decisions during the course of an exam?
Again, the PR is the face of the partnership and decision-maker in the eyes of the IRS, but the PR might not even be a partner in the partnership; thus the PR is going to require/need the cooperation of the partners in the partnership to be successful. The operating agreement should ensure that cooperation happens and provide remedies in the event partners fail to cooperate. The agreement should include provisions requiring the timely provision of information and documentation. Further, it should provide the PR with the ability to compel partners to take certain actions, like paying liabilities or filing amended partner level returns.
4. Does the partnership or operating agreement articulate who will be responsible for tax deficiencies in the event of adjustments during the course of an exam?
One of the most obvious problems associated with the new centralized audit regime is one of timing. The partnership will be assessed income for any "reviewed year." A "reviewed year" is any year that is open for audit. On the other hand, the payment takes place in the "adjustment year," which is the year the examination is resolved. This could lead to the burden of the tax deficiency ultimately falling on some partners who may not have been partners in the partnership during the “reviewed year.” Hence, it is crucial that the operating agreement cover who will be responsible to tax deficiencies, penalties, and/or additions to tax.
First, the agreement should address how and when the PR and the partners will utilize the mechanisms available to reduce the deficiency (imputed underpayment) proposed by the IRS. Under the centralized audit rules the PR may: (1) have the reviewed-year partners file amended returns taking into account all partnership adjustments allocable to those partners and pay the related tax; (2) demonstrate that any or all of the imputed underpayment is allocable to a tax-exempt entity; or (3) demonstrate that a portion of the imputed underpayment is allocable to corporations or individuals with a tax rate that is higher than the highest statutory rate in place.
Second, the operating agreement should provide provisions concerning when and if to make a “push-out” election to the reviewed year partners and notify the reviewed year partners of the applicable safe harbor amount they may pay. A partnership may elect to push out the imputed underpayment and any penalties, to the reviewed year partners. This election must be made within 45 days of receipt of a notice of final partnership adjustment. The partnership must provide the IRS and all partners with a statement of each partner’s share of any adjustments to items of income, gain, loss, deduction, or credit within 60 days of the final determination of the adjustments.
Third, the operating agreement should address the rights, obligations, influence, and control of partners who have exited the partnership in the event of an examination of a year in which they were a partner (a reviewed year partner) and may be ultimately responsible for the liability. In other words, the agreement should address whether reviewed year partners have any influence or control over the PR’s decision to make a push-out election or otherwise bind the reviewed year partners to an adjustment and the ultimate liability therefore.
5. Does the partnership or operating agreement address and contain procedures for submitting an Administrative Adjustment Request?
Amending tax returns is no longer an option for partnerships under the centralized audit regime. Instead of filing amended tax returns, partnerships must now submit Administrative Adjustment Requests (“AARs”). AARs must also be filed in the event examination where the partnership makes a push out election for the adjustments to go to the reviewed year partners. The process does not end with filing an AAR, however, and several additional forms may need to be filed or completed – Forms 8986. 8985, and 8978. Note, all of these Forms are still in “Draft” form and have yet to be finalized by the IRS.
A Form 8986 is used by the partnership to furnish and transmit each partner’s share of adjustments to partnership-related items and includes the details related to those adjustments. The Form 8985 summarizes the Form 8986 and is submitted with the Form 8986. Finally, a Form 8978 is filed with a partner’s federal income tax return for the reporting year, the year in which the Form 8986 was received, and actually reports the adjustments shown on the Form 8986 at the partner level.
The operating agreement should address what influence the partners have on this new process for reporting changes to the original partnership return and how that influence is exerted.
- The IRS examinations of partnerships will increase in the near term.
- The 2018 tax year is the generally the first year in which the new Centralized Audit Regime will be applicable to partnerships.
- Under the Centralized Audit Regime the IRS determines adjustments and, in general, determines, assesses, and collects tax at the partnership level, not at the individual partner level.
- The Partnership Representative has sole authority to act on behalf of the partnership during an exam under the Centralized Audit Regime.
- Partnership or Operating Agreements need to address and account for the Centralized Audit Regime and articulate the limitations, obligations, and indemnifications of the Partnership Representative at a minimum.
- If you need to update your partnership or operating agreement or want a fresh set of eyes to review it, reach-out to David M. McCallum, Special Counsel and your Nexsen Pruet Tax Team.
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