The IRS issued Regulations significantly altering partnership audit rules for partnership tax years beginning after December 31, 2017. These new rules are called the Consolidated Partnership Audit Regime (CPAR). They are intended to allow the IRS to efficiently audit, assess, and collect taxes at the partnership level.
Partnership agreements may need amendments to address several critical elements to changes in the law and associated regulations to avoid negative consequences.
When the IRS audits a partnership under CPAR, the IRS may assess a partnership level “imputed underpayment,” at the top available tax rate (individual or corporate) in effect at the time of the net audit adjustments. The tax may be paid at the partnership level with certain adjustments. The partners may then elect to amend returns to reflect the audit adjustments, or the imputed underpayment may be passed out to the partners for payment. An audit of the partnership does not bar the IRS from opening an examination of the partners to seek tax assessments at the partner level.
As noted above, the partnership may pay the tax on the imputed underpayment at the top tax rate with no offsets for suspended passive losses, capital losses, net operating losses, etc., which may be available if the partnership attributes were pushed out to the partners. There is neither self-employment tax nor net investment tax assessed on the imputed underpayment.
For assessments of imputed underpayments at the partnership level, adjustments are allowed if any of the partners are tax exempt under 168(h)(2).
How Is the Law Changing?
The first important change in the law and supporting regulations which may require an update to partnership agreements is the creation of a new position of authority called the “Partnership Representative” (PR). The PR can bind the partners—similar to the old Tax Matters Partner, but with more power.
CPAR sounds like a simple, efficient, and straightforward way for the government to collect taxes at the common, partnership level at which the income is earned. That is, until you consider several facts:
- The members who are in the partnership in the period defending the partnership examination may differ from the members invested in the partnership in the period under audit.
- Not all investors in the partnership will be subject to tax at the highest available tax rate. Therefore, using the highest available tax rate will likely lead to the government collecting excessive taxes.
- If there are tax-exempt members in the partnership, and the PR claims exemption from the portion of the imputed underpayment on behalf of the exempt partners, the partnership agreement must allow for a special allocation to provide the benefit of the exemption to flow to the tax-exempt partner(s). Failing to provide the PR with this authority may lead to the PR and other partners being assessed penalties for receiving private inurement from a public charity, or engaging in self-dealing if the non-profit is a private foundation.
Mitigating the CPAR Rules’ Impact
There are three ways to mitigate the impact of the CPAR rules:
- If the partners are qualifying members, elect out of the CPAR rules by filing an election each year with the timely-filed partnership return;
- Partners may amend tax returns for the imputed underpayment (partner by partner choice); or
- “Push out” – The partnership may elect to force the partners who were partners in the year under review to report the audit adjustment at the partner level by furnishing to each partner a statement showing their share of adjustments items.
We believe most partnerships will want to exercise option #1 and elect out of the CPAR rules, if possible. This forces the IRS back to the pre-CPAR rules auditing under the old TEFRA rules, where assessments are made at the partner level rather than at the partnership level.
Only eligible entities may elect out of CPAR. An eligible entity is a partnership with 100 or fewer K-1s (includes underlying S corporation owners), and the owners can only be individuals, deceased partner’s estates, C corporations, S corporations, and foreign “per se” corporations.
If the partner group for the year includes any of the following, the partnership cannot elect out of CPAR: trusts (including grantor trusts), partnerships, disregarded entities (single member LLCs), nominees or other types of estates. It should also be noted that married couples are counted as two members. Tax exempt partners look not to their tax status, but their organizational status.
If the organization is a corporation, the organization is not a disqualifying member. In this circumstance, the PR may elect out of CPAR, assuming there is no other disqualifying factor. However, if the tax-exempt partner is a trust, it is a disqualifying member precluding the PR’s election out of the CPAR rules.
What Should Your Partnership Do Now?
Partnerships need to review and update their partnership agreements immediately to:
- Ensure the partnership agreement names a Partnership Representative. The Partnership Representative need not be an owner in the partnership. If an entity is the Partnership Representative, the partnership is required to name a “Designated Individual,” which can be an individual who holds a specified position, such as CFO of XYZ corporation. If the partnership has not designated a Partnership Representative, the IRS, on examination, may appoint a Partnership Representative to represent the interests of the partnership. If this occurs, the partnership may not change the Partnership Representative without the consent of the IRS.
- Because the IRS will name a PR if the partnership has not done so, the partnership agreement should not only name a PR, it should outline the process to appointing the successor representative. This ensures there is never a void in the position.
- Amend the partnership agreement to enumerate the duties and responsibilities (power) the IRS regulations confer on the Partnership Representative. The CPAR regulations give broad authority to the PR. The partnership may want to provide additional responsibilities. If the partners desire to limit the PR’s authority, it will not be binding on the IRS. However, it may be possible to bind the Partnership Representative to the other partners through an indemnification clause if the PR engages in unauthorized activities or acts in ways the partnership has expressly prohibited.
- Examples of issues the partners may want to address in the partnership agreement include:
- What permissions do the partners want to confer on the Partnership Representative?
- What elections should be made and when?
- What portion of the partners must approve the IRS settlement (technically none in the eyes of the IRS)?
- When does the partnership require the partners to amend their tax returns (again this is a decision the IRS empowers the PR to unilaterally decide on behalf of the organization)?
- When can the partnership elect to “push out” imputed underpayments?
- We recommend the Partnership Representative develop and document a process for keeping a list of all partners and the type of entity they are, including tax status, over time. Each time the list changes, the Partnership Representative should mark the date and the change in ownership. These records should be maintained in accordance with the organization’s document retention policy—normally 6-8 years.
- If there are 100 or fewer partners, and there are no disqualifying classes of partners, the Partnership Representative should consider opting out of the new audit rules by filing an election on a timely-filed Form 1065 each year. The partnership agreement may formalize the decision it wants the PR to make, but it is not binding except through a civil action against the PR.
- Each year, the Partnership Representative should notify the partners with a statement attached to their K-1. The statement should state whether the partnership has elected out of the federal consolidated audit provisions for the tax year reporting the Schedule K-1 tax information. This could affect the value of the partnership investment for the year and let the investors in the partnership know what level of documentation they must maintain.
- If an IRS audit occurs and there is an imputed adjustment, the partnership should know how the Partnership Representative handles the distributions (for current & past partners).
- The partnership may also want to consider possible restructuring to meet the elect-out provisions for an eligible entity.
The Bottom Line
The implications of these partnership agreement changes can have an important impact on their partners. Now is the time to make sure the partnership agreement is in alignment with what all the partners want and need, considering future changes to the partnership itself and its respective partners.
Please contact us if you would like to discuss changes in the partnership audit rules or review your planning opportunities.
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