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February 29, 2016 Experts Corner

Partnerships must brace for new IRS audit rules

Daniel L. Gottfried
By Daniel L. Gottfried

With 2015 in the rearview mirror, members of partnerships should consider a recently passed law that may have significant implications for the future of their partnership in the event of a tax audit. Signed into law in November, the Bi-Partisan Budget Act of 2015 (2015 Act) has created a need for nearly all entities treated as a partnership, including limited liability companies (LLCs), to take another look at their partnership agreements' tax provisions and make necessary revisions.

The 2015 Act completely overhauled the Internal Revenue Service's audit procedures for partnerships, effectively repealing the existing Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) and Electing Large Partnership audit procedures. These changes are intended to make the audit process easier for the IRS and generate as much as $10 billion in additional tax revenue over the next decade, but they'll also have a potentially significant impact on many partnerships.

In the past, it has been difficult for the IRS to audit partnerships, resulting in audit rates as low as 0.8 percent, according to one Government Accountability Office report. This is due, in part, to the fact that the IRS generally performs audits at the partnership level, but then makes tax adjustments, and collects any additional taxes, interest, and penalties from individual partners.

The new audit procedure seeks to streamline that process.

Under the new procedures, the IRS would review partnership income, gain, loss, deduction, credit, and partners' distributive shares for the relevant year. If that audit necessitates an adjustment, any underpayment would need to be paid by the partnership, rather than individual partners.

This payment would need to be satisfied by the partnership's assets, or with contributions from those who are partners at the time of the adjustment, not in the year under audit. In other words, the individuals or entities who are partners at the time of an audit will bear the costs of any adjustments, regardless of whether or not they were partners in the year that is actually being audited.

In light of these changes, partnerships may want to consider one of two different approaches for handling their taxes. First, certain partnerships with 100 or fewer qualifying partners are eligible to opt out of the new procedures, in favor of the old system. Second, it is possible to shift the burden of any tax adjustment to those who were partners in the year under audit. Given the complexity of these approaches, however, partnerships should allow time for careful analysis, planning, and revisions to their partnership agreements.

While legal experts are still developing best practices as a result of these changes, partnerships should take a closer look at the implications of the new procedures sooner rather than later in order to make sure they are protecting themselves.

For example, partnerships that are undergoing an ownership change or taking on new partners will need to consider the new procedures and make necessary revisions to their agreements. After all, these types of changes create a potential mismatch between who generates a partnership's income and who would bear the cost of a tax adjustment.

In addition, partnerships that have audited financial statements will need to understand whether the changes may result in a financial statement impact for uncertain tax positions, which historically may not have been relevant to those partnerships.

Although there is ample time to prepare for the new audit procedures, these changes create real risk for partnerships, and make previously boilerplate tax provisions obsolete.

Daniel L. Gottfried is a partner at Hinckley Allen in Hartford.

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