Posted by The TaxAdvocate Group, LLC

What the New Centralized Partnership Audit Regime Means for You

What the New Centralized Partnership Audit Regime Means for You

If you have filed a partnership tax return, for any tax year that began after December 31, 2017, you can expect a federal audit of your return that will be completely different from any past audits you may have experienced. Under the TEFRA audit -- the previous partnership audit regime -- the individual partners were held liable for any tax implication that resulted from the IRS audit. Under the new centralized audit, known as the BBA, the partnership would have to bear a tax liability if any audit adjustment were made to a partnership-related item. The new rules, which are aimed by the IRS at a simplified audit process that would ease collection, could lead to many more audits of partnership tax returns.

In the new audit regime, an audited partnership will enjoy three general choices: 

  • The partners could choose not to be subject to the new rules. They would continue to be audited in accordance with the old rules (TEFRA).
  • They could opt to be entirely subject to the new audit regime. Thus, after the completion of the BBA audit, the partnership would bear any additional tax liability that arises, including penalties and interest.
  • The partners may express a desire to be partially subject to audits under the new rules. Thus, after the completion of the audit at the partnership level, the additional tax liability, if any, would be borne by the individual partners.

In this article, we will take a look at how a partnership can qualify to elect out (the first choice listed above), the mechanics relating to such choice, and what the choice implies.

We will also look at the provisions relating to the other two choices in dedicated articles that will also include comments on the replacement of the Tax Matters Partner appointed under the old audit rules (TEFRA) by the Partnership Representative appointed under the new rules (BBA).

Who Can Qualify to Elect Out?

A partnership that decides on the first option must satisfy two requirements before electing out:

  • The partnership must comprise of "eligible partners" as defined under the rules. Such eligible partners would include any individual partner, a C corporation, an S corporation, and a foreign entity that would qualify to be treated as a C corporation if such entity were a domestic entity. The estate of a deceased individual could also be considered as an eligible partner. 

Note: the mere fact that an S corporation has a shareholder who does not qualify to be an eligible partner under the rules does not disqualify the S corporation from being considered an "eligible partner".

Under the rules, the inclusion of any of the following types of partners would not satisfy the requirement of "eligible partner":

  • If the partnership has as a partner a bankruptcy estate, a foreign entity that would not qualify to be treated as a C corporation if such entity was a domestic entity, or a disregarded entity, such as, for instance, a trust or grant or LLC qualified Subchapter S subsidiary comprised of a single member, such partnership would not qualify as comprising of eligible partners. Similarly, a partner of a partnership would not be considered an eligible partner, if such entity were a trust, a partnership or a nominee or any other entity holding interest on somebody else's behalf.
  • The partnership must have no more than 100 partners during the relevant tax year. The number of partners will be calculated by counting the number of K-1s the partnership has issued during the tax year. For instance, if an eligible partner of the partnership is an S corporation, the number will be a count of not only the K-1 issued to the S corporation but also the number of K-1s issued to shareholders of the corporation. If the partnership includes estates as partners, such estates will not be subject to any "look through" rule, regardless of whether they have issued K-1s to the beneficiaries of the estate. While spouses with individual partnership interests will be counted as two partners under the “100 or fewer test,” any spouse living in community property state will not qualify as an additional count even though he/she may own a partnership interest.

The Mechanics Relating to Electing Out

The partnership that elects out will be given the choice every tax year provided such partnership has filed its tax return promptly, including any extensions, for the relevant tax year. To choose to elect out, the partnership is required to check a box in the tax return and provide detailed information about every partner it had during the tax year in question. The information would include names of the partners, their federal tax classification, and a statement affirming that the partner named qualifies to be called an eligible partner. If an S corporation has been named as a partner, information, as described above, must be divulged in respect of every individual who was a shareholder of such corporation during the relevant tax year. The absence of such information would invalidate the election for the tax year in question.

Apart from the disclosure of information as above in its tax return, the partnership is required to furnish each partner with an annual statement wherein it must notify the partners about the election made by the partnership under the centralized partnership audit rules. Such notice must be issued within 30 days of the said election. The notification does not have to adhere to any set format. If the partner notified is an S corporation, the notification need not be sent to individual shareholders of the S corporation. The S corporation partner is left free to decide whether and in what manner it chooses to notify its shareholders.

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