IRS regulations are constantly changing, and this could affect your tax compliance and filings. As such, it’s vital that your partnership stays up to date on these changes. For example, starting in 2015, partnership audits fell under what was known as the ‘Bipartisan Budget Act (BBA) regime’. These audits took place at the partnership level, with the IRS assessing and collecting tax from each partner separately.
Now, the IRS has implemented new partnership audit rules, in an attempt to restore fairness in tax compliance.
But how do these new rules affect you?
Understanding the New Partnership Audit Rules
With the help of artificial intelligence (AI), the IRS is focusing its attention on large or complex partnerships. However, all partnerships are subject to the new rules for returns for tax years beginning in 2017, unless they are allowed to opt out.
The new rules affect how audits are conducted, how adjustments are made, and how payments are processed.
Previously, partnerships were audited at entity level, but assessments and collections were made at an individual partner level. The new audit rules allow the IRS to impose an entity-level tax directly on the partnership in the year in which the audit is finalized. This includes penalties and interest.
Unfortunately, this means that the burden to pay falls to partners at the time of finalization, even if they weren’t members of the partnership when the audit began, and the liability doesn’t relate to them. As such, newly admitted partners could be paying a tax liability for retired partners.
Moreover, these payments are calculated using the highest applicable federal tax rate.
Finally, the new rules introduce a partnership representative to replace the tax matters partner of the previous regime. The representative acts as the sole point of contact between the IRS and the partnership.
Reasons behind the changes
Previous attempts to audit partnerships generally only resulted in modest adjustments, and the administrative process was challenging for both the IRS and taxpayers. In addition, the IRS noticed a decline in audit rates for partnerships over the past decade. As such, the new rules are designed to streamline the process, improve the IRS’s ability to audit partnerships effectively and ensure tax compliance.
With the addition of AI technology, the IRS hopes to learn more about the compliance risks presented by complex partnerships, to better focus future audit activity.
Impact on Partnerships
The changes to these audit processes effectively increase the liabilities and responsibilities of individual partners. And with the use of the highest applicable tax rate, this may also mean steeper tax assessments and penalties.
However, there is an option to shift responsibility back to the liable partners. The election must be done within 45 days of receiving the notice of final partnership adjustment, through a revised Schedule K-1. Thereafter, the liable partners need to adjust their tax liabilities for the year in question, and report any resulting increases, at an interest rate 2% above the normal underpayment rate.
This election depends on a number of considerations, and it’s best to consult with a tax professional if you want to shift liability.
Preparing for an Audit Under the New Rules
To prepare for an audit, you’ll need to designate a partnership representative. This can be an individual or entity. The importance of choosing the right representative can’t be overstated. Under the new audit rules, partners retain no rights in administrative proceedings. As such, you can’t contest IRS determinations separately from the partnership. Instead, your partnership representative has sole authority to act on behalf of your partnership, and their actions are binding, regardless of any restrictions in your partnership agreement.
For example, they can extend the statute of limitations, protest any adjustments, or settle with the IRS. If you don’t designate your own representative, the IRS will appoint one for you.
Also, if you receive a notice of selection for examination, you have a very narrow window of opportunity to file an administrative adjustment request (AAR) to correct an item on your original return. This has to be done within 30 days.
The importance of documentation and record-keeping
Keeping accurate and organized records not only provides a clear snapshot of your financial activities, but also shows that you are committed to compliance. Our CPAs advise that you organize your income statements, receipts, and supporting documentation by date. This includes evidence for any deductions or credits claimed.
To help with this, the IRS provides guidelines on the documentation they often request.
If you’re in doubt about your records or need further guidance on record keeping, speak to one of our CPAs.
Changes in partnership agreements
To safeguard your partnership against the effects of the new audit rules, you may need to revise your partnership agreement.
These agreements should include clauses covering indemnity obligations and distribution holdbacks. In addition, they must include the delegation of a partnership representative, and processes surrounding opting out of the new partnership audit regime, if your partnership is eligible.
Opting Out of the New Audit Regime
It is possible to opt out of the new partnership audit regime. This is advisable if your partnership has recent changes in partners, needs to make changes to a previous return, or if partners simply aren’t subject to the 37% tax rate. However, in order to do so, your partnership must comply with the eligibility criteria.
This includes:
- Having fewer than 100 partners consisting exclusively of individuals, C corporations, S corporations, estates of deceased partners, and foreign entities that would be treated as C corporations if they were domestic.
- All partners are eligible during the entire tax year (i.e. those who will be issued a Schedule K-1). Ineligible partners include a partnership, trust, disregarded entity, and qualified subchapter S subsidiaries (QSubs).
- Opting out annually. Failing to opt-out in a particular year will subject your partnership to the Centralized Partnership Audit Regime.
How to opt-out
There are three options to elect out of the new partnership audit regime.
Section 6221(b) election: This lets partnerships opt back into partner-level collection, to save on state income taxes and offset the higher rates associated with the new regime.
The Section 6225 option: Here, your partnerships can reduce taxes owed in certain situations, through filing an amended Schedule K-1. As such, it’s beneficial if partners have entered or exited the partnership. However, it requires the participation of partners from previous years.
Section 6226 election: This enables partnerships to shift responsibility to the partners, by issuing a statement within 45 days of receipt of an IRS notice of adjustment. As such, each partner becomes responsible for their share of the adjustment tax.
The process
Partnerships that elect to opt out of the new partnership audit regime should do the following:
- On Form 1065, answer ‘yes’ to the question ‘Is the partnership electing out of the centralized partnership audit regime under section 6221(b)?’ This is question 31 on the 2023 version of the form.
- Complete Schedule B-2 of the form, by listing each eligible partner’s name, type, and Taxpayer Identification Number.
Electing to opt out of the new partnership audit regime is binding, unless the IRS determines that your election is invalid.
Strategies for Minimizing Audit Risk
Because audits aim to ensure that your partnership information is reported correctly and verify that the reported amount of tax is correct, it’s essential to fill out your returns correctly. Mistakes such as missing income or questionable deductions can land you in hot water.
That’s why it’s important to implement robust internal controls and compliance checks. This extends to your financial reporting. Maintaining meticulous financial records is the best way to prepare for an audit. Not only do they make tax filings easier, but clear records help you provide evidence to any queries.
It’s also a good idea to engage with tax experts for audit preparation and compliance. Also, they’ll be able to help you make the best decisions for your partnership when faced with a notice of examination.
If you have queries about the audit process under the new partnership tax audit rules, schedule a Discovery Call with one of our CPAs.
The information presented in this blog article is provided for informational purposes only. The information does not constitute legal, accounting, tax advice, or other professional services. We make no representations or warranties of any kind, express or implied, about the completeness, accuracy, reliability, suitability, or availability of the information contained herein. Use the information at your own risk. We disclaim all liability for any actions taken or not taken based on the contents of this blog. The use or interpretation of this information is solely at your discretion. For full guidance, consult with qualified professionals in the relevant fields.
