When it comes to tax planning, there’s little room for error. Making a mistake on your return could lead to an audit, which can be both time-consuming and stressful.
In an effort to streamline the audit process, new guidelines for audits involving partnerships were established as part of Bipartisan Budgeting Act of 2015. These guidelines, which took effect January 1, 2018, are a replacement for the partnership audit rules under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA).
While you may not be anticipating an audit any time soon, it’s important to understand how the new rules could impact your business.
Who Do the New Rules Apply To?
Broadly speaking, the new rules cover any business entity that elects to be taxed as a partnership. That includes limited liability companies with multiple owners.
The updated rules apply to partnerships with 10 or more partners. Smaller businesses with fewer partners would continue to be audited at the partner level. Partnerships with more than 10 but less than 100 partners may be able to opt out of the new rules and be audited at the partner level also.
To opt out, every partner must be a qualifying partner. That includes individuals, C-corporations, S-corporations or an estate of a deceased partner. “Opt-out isn’t allowed if a partnership includes a non-grantor trust or partnership as a partner,” says Mario Costanz, CEO of Happy Tax, headquartered in Miami Beach, Florida.
Additionally, only partnerships that are required to provide 100 or less K-1 statements can choose to opt out. Those narrow guidelines could make it difficult for even very small businesses or businesses with tiered structures, such as multiple LLCs, to opt out.
The Role of the Partner Representative
The new rules specify that one person will represent the entire partnership in an audit. This individual has a fairly broad scope of authority, which includes deciding how and whether to settle the audit, meeting all notice and service requirements and taking any other action necessary to complete the audit process.
“The individual decisions of the representative partner can have huge impacts on the other partners in the business,” Costanz says.
It’s to your business’ advantage to discuss who will act as the partner representative, and what responsibilities that entails sooner, rather than later. If not, “the partnership may inadvertently expose itself to financial and legal risk,” Costanz says. He recommends amending your partnership agreement if necessary to outline the scope of the partner representative’s authority in case of an audit.
Your partnership agreement should address whether the representative can extend the statute of limitations, settle an audit or hire outside advisors and attorneys. “There should also be clear terms regarding how decisions affecting the partnership will be made during the audit, as well as the procedure for removing a partnership representative if necessary,” Costanz says.
Tax Collection and Assessment
The new rules also affect how tax assessments and collections are handled during an audit.
“Under the prior law, an adjustment was made to the partnership’s taxable income following an audit,” says Michael Kouyoumdjian, managing shareholder for RP&B CPAs located in Riverside, California. “Until 2018, the partnership’s taxable income flowed through to the partners and was ultimately reflected on each partner’s individual tax return.”
With the new rules, the IRS audits partnerships and LLCs for a specific tax year, which is the reviewed year. Adjustments are then made at the partnership level, and taken into account by the partnership in the year the audit is completed. Assessment and collection of tax, including any penalties or interest owed, also occurs at the partnership level.
“This means that a member who joined an LLC after it was formed holding a membership interest during an adjustment year will bear the tax liability assessed at the partnership level,” Kouyoumdjian says, “despite not holding an interest during the reviewed year.” By the same token, because adjustments no longer flow through to individual members, a former member who holds interest during the adjustment year wouldn’t bear the tax liability of the tax year being audited.
Essentially, these provisions place the burden of paying any additional tax due on the partners of the adjustment year, not the individuals who were partners during the reviewed year. An exception would apply if your partnership agreement assigns a shared responsibility to all partners, regardless of when they held an interest in the business.
The rules also specify a consistency requirement, meaning that partners must treat income, gains, losses deductions or credits consistently on both their partner returns and the partnership return. It’s possible to avoid this requirement by filing a statement that specifies any inconsistency between the two on Form 8082.
Preparing Your Partnership
The new audit rules are meant to make auditing larger partnerships easier for the IRS but smaller partnerships still need to understand how they could be affected. If you fall into the more-than-10-but-less-than-100 partner category, you should carefully consider how your business would handle an audit scenario.
Start by discussing with your partners and your accountant whether you qualify to opt-out of the rules, and whether that makes sense. Your accountant or chief financial officer can help you determine how being audited at the partner versus partnership level may impact your tax liability.
If you elect to be audited under the new rules or you’re not eligible to opt out, decide who will act as partner representative in the event of an audit. Take time to review your partnership agreement and spell out the representative’s duties and responsibilities.
Finally, you should create a plan with respect to whether and how individual partners should be required to disclose personal assets or other financial information. “Partnerships should plan ahead to make sure private financial information isn’t disclosed unless absolutely necessary,” Costanz says.
Remember, an audit may not be pleasant but it isn’t the end of the world. Planning ahead can make it easier to navigate if your partnership is singled out by the IRS.
This should not be construed as tax or financial advice. You should always confer with your accountant or financial consultant before making a financial decision for yourself or your company.
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Rebecca Lake, Spark Contributor
Rebecca Lake has been writing about small business, finance and investing for nearly a decade. Her work has been featured on a number of top finance sites, including The Huffington Post, Fox Business and U.S. News. Follow her on Twitter @seemomwrite or check out her profile on LinkedIn.