Starting on January 1, 2018, a new IRS regime for auditing partnerships will start.
Enacted as part of the Bipartisan Budget Act of 2015, these new rules intend to make it easier for the IRS to collect tax deficiencies from entities taxed as a partnership.
The fact that it was a bipartisan Congressional act was a bright red flag that something bad for taxpayers was on the way.
Why the new rules?
First, Congress needed some gimmick that for political purposes theoretically provides enough additional tax money to offset increasing pork spending in the budget.
Second, the IRS had difficulty chasing down individual partners to get them to pay tax on deficiencies incurred at the partnership level.
The result is that life for taxpayers treated as partners for federal tax purposes just got more complicated—and expensive.
The federal taxation of entities treated as partnerships is always problematic. There are over 1 million partnership type entities, and the tax intricacies involved are exponentially complex.
Computing and complying with the federal income tax rules is always challenging even by the most honest of taxpayers using high price specialized tax experts.
For the IRS to find a tax deficiency when doing a partnership audit is a commonplace event.
Before this new law, the tax deficiency of a partnership was payable by the individual partner who picked up the partnership items on their tax return.
Now, when the IRS asserts a tax deficiency (with interest and penalties) at the partnership level, the partnership pays the tax and not the individual partners.
The partners become liable for the imputed tax even though there may have been changes in who were the partners during the prior years now audited.
Even though the partnership agreement may have specific provisions on allocating liabilities, that becomes a problem for the partners to sort out and is no longer a concern of the IRS.
Certain qualifying partnerships—those being under 100 qualifies partners –can “push-out” the tax deficiency to individual partners where the IRS knows the identity and location of the partners in the year under audit.
Even this process has its twists and turns. Limited liability companies should make sure they have a proper check-the-box election filed. And not all partners will be deemed qualified for this purpose.
What will be the tax rate?
The “imputed underpayment” of tax assessed at the partnership level is the highest tax rate applicable to an individual. It’s up to the partnership to inform the IRS of each partner’s tax status, and the character of income recognized, to claim any reduction of the assessment.
Who in the partnership has the legal right to deal with the IRS for all?
Partnerships were already required to have a “tax matters partner” to be responsible for tax compliance. This new law adds the requirement of a “partnership representative,” who need not be a partner, to have broad powers and be the exclusive authority to bind the partners in resolving the IRS audit.
The role of partnership representative promises to be a thankless job. Intra-partnership disagreements over allocating liability and money are rarely friendly and commonly wind up in costly litigation.
The IRS has issued guidance, but it is sparse. All new regulations are on hold because of the President’s Executive Order dealing with governmental regulations.
The end of the year is rapidly coming, and this new tax regime will shortly come into force potentially impacting every existing partnership.
Changing any partnership agreement to meet new onerous tax complications is time-consuming. The more partners, and tiers of partnership, the more difficult the logistics even on simple matters.
The action step to take now is to start the process of reviewing and modifying your partnership agreement to conform to the new IRS partnership audit regime.
Denis Kleinfeld is known as a strategic tax and wealth protection lawyer, widely published author and creative teacher.
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