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B.B.A. Partnership Audit & the I.R.S. Centralized Partnership Audit Scheme

B.B.A. Partnership Audit & the I.R.S. Centralized Partnership Audit Scheme

On November 2, 2015, President Obama signed the Bipartisan Budget Act (B.B.A.) of 2015, which included a new federal audit regime for businesses and entities classified as a partnership for federal income tax purposes (the New Rules). The new rules, effective for partnership tax year revisions beginning January 1, 2018, generally allow the I.R.S. to adjust the income, gains, losses, deductions, or credits of a corporation and to collect any resulting underpayment of taxes at the partnership level. 

Before the enactment of the New Rules, purchasers of the partnership's stock were primarily focused on due diligence and obtaining claims and indemnification agreements concerning taxes on nonprofit profits calculated at the partnership's level for taxable periods ending on or prior to the closing date of the acquisition (pre-closing periods). 

Purchasers were generally not concerned about federal income taxes imposed on the partnership's income in the periods leading up to pre-closing periods, as these taxes were paid by the direct or indirect partners of the target partnership rather than the partnership itself. 

Prior to the new rules, if there was a federal income tax audit of a partnership in connection with a period before closing, any resulting assessment would generally be made against the partner's precedents, and the partnership interest buyer would be unaffected. However, implementing the new rules would expose the purchaser of the partnership interest to liability for underpayment of federal income tax on partnership income during a pre-closing period commencing on or after January 1, 2018. 

In other words, once the buyer has acquired an interest in the partnership, the I.R.S. can determine an underpayment charged to the partnership for a pre-closing period. Suppose the partnership does not make a Push Out election. In that case, the buyer will bear the economic burden of underpayment, either because the partnership fulfills its obligation with its resources or because it needs capital from partners present, including the buyer, to fulfill the obligation. 

Therefore, for partnership purchases after January 1, 2018, purchasers should perform due diligence on uncertain or aggressive positions taken by the partnership to determine its taxable income. In addition, purchasers should ensure that tax returns and transaction offsets for periods before closing include federal income tax coverage for partnership income.

What Business Partners Need To Know

Among the many priorities of the Internal Revenue Service (I.R.S.) is meeting federal partnership income tax obligations. Recently, the I.R.S. has implemented two major programs specifically focused on partnership tax enforcement, and we expect to see increased activity in both programs in 2022 and beyond. Let's discuss some of the implications of these recent developments for business partners:

50 percent of all partnership audits lead to changes in the value of taxes owed

According to I.R.S. data, 50% of all partnership audits for tax years 2016 to 2019 resulted in changes to the amount of tax owed. Although this includes both upward and downward adjustments, it is reasonable to assume that most of these changes increased the federal income tax on the partnership. This high rate of inaccuracy is exactly why the I.R.S. prioritizes partnership tax enforcement.

I.R.S. B.B.A. Partnership Audit Process and Centralized Partnership Audit Regime

The I.R.S. currently partnership tax evasion through two main programs: (i) the B.B.A. partnership audit process and (ii) the centralized partnership audit regime. While these aren't the only ways the I.R.S. targets partnerships, they have become popular in recent years.

1. B.B.A. Partnership Audit Process

As explained earlier, the IRS BBA audit process was created as part of the Bipartisan Budget Act (B.B.A.) of 2015. Under this program, the I.R.S. selects business income for review based on a preliminary analysis and notifies the selected partnership by issuing letter 2205-D. Specifically, the I.R.S. sends the 2205-D letter only to the designated partnership address and not to the individual partners responsible for the partnership's tax liability.

A BBA partnership audit is a long and structured process. Although partnerships can "opt-out" of the B.B.A. program, there are pros and cons.

2. Centralized Partnership Audit Regime

The Centralized Partnership Audit System is an initiative to improve the efficiency of the Internal Revenue Service's partnership audit process and improve compliance with partnership liability for non-payment of taxes. As part of the B.B.A. partnership audit process, partners can "reject" charged default payments, provided they meet certain requirements. Through the Centralized Partnership Audit Program, the I.R.S. attempts to limit the use of this "opt-out" option to appropriate circumstances and ensure that all taxes owed by individual partners are collected.

Bottom Line

Given the I.R.S.'s emphasis on partnership tax enforcement, business partners should prioritize tax compliance and be prepared to deal effectively with the I.R.S. during a partnership tax audit. Please contact a tax professional, such as DENNIS JAO, for a confidential consultation if you want to know more.



Dennis Jao
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