On Nov. 2, 2015, President Barack Obama signed the Bipartisan Budget Act of 2015 into law. In addition to lifting mandatory spending caps and raising the federal debt ceiling, the legislation contains important tax provisions that significantly alter partnership audit procedures.
Current Partnership Audit Procedures
Under current law, three separate regimes exist for auditing partnerships:
- For partnerships with 10 or fewer partners, the audit procedures for individual taxpayers generally apply.
- For most partnerships with more than 10 partners, the IRS conducts a single administrative proceeding under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) rules, which dictate that any audit adjustments flow through to individual partners for the taxable year to which the audit relates and generally require the filing of an amended prior year tax return at the individual partner level to take any adjustments into account.
- For partnerships with 100 or more partners that elect to be treated as electing large partnerships (ELPs) for tax reporting and audit purposes, ELP audit procedures apply.
Under all three of the current audit regimes, audit adjustments ultimately are taken into account at the individual partner level, with individual partners bearing responsibility for paying any resulting federal income tax liability (including penalties and interest, if applicable) relating to partnership audit adjustments.
New Partnership Audit Procedures
The Bipartisan Budget Act of 2015 eliminates the TEFRA unified partnership audit rules and the ELP rules in favor of more simplified audit procedures that entail the IRS auditing partnerships and their partners at the partnership level. The new audit procedures will apply to partnership returns filed for tax years beginning after 2017. However, a partnership may elect to apply the new audit rules to taxable periods beginning after the Nov. 2, 2015, date of enactment.
Under the new procedures, when the IRS audits a partnership, all adjustments will be taken into account by the partnership, not the individual partners, in the year in which the audit is completed. Significantly, this means that the partnership, and not the partners, will be required to pay any federal tax liability as well as any related penalties and interest from the audit.
The new law also provides two elections that modify the application of the new rules:
- Election out of payment at the partnership level. The partnership can elect to issue adjusted Schedule K-1s, “Partner’s Share of Income, Deductions, Credits, Etc.,” to its members for the adjustment year in lieu of paying the tax in the year in which the audit is completed. The partners receiving the adjusted K-1s would be required to amend their returns through a new, simplified process.
- Election to opt out of entity-level audit procedures. Partnerships with 100 or fewer qualifying partners may elect to opt out of the entity-level audit procedures. For this purpose, qualifying partners include:
- C corporations, including comparable foreign entities
- Real estate investment trusts
- Regulated investment companies
- S corporations
- The estate of a deceased partner
Notably, tiered partnerships cannot elect out of entity-level audit procedures.
The election to opt out of the entity-level audit procedures is an annual election filed with a timely filed tax return. To opt out, a partnership must notify the partners of the election to opt out and must disclose the names and taxpayer identification numbers of each of its 100 or fewer partners, including S-corporation shareholders (in calculating the 100 partner limit, there is a look-through rule that treats each shareholder of the S corporation as a partner).
The procedures radically change the audit process for partnerships and will force partnerships to consider their elections with the filing of each return. Partnerships also may need to consider amending their agreements to account for the new audit procedures.