The Bipartisan Budget Act of 2015 introduced a “centralized” partnership audit regime that took effect in January 2018. Partnerships — including LLCs taxed as partnerships — should pay close attention to these rules. You might assume that audit rules are merely procedural, but the new rules made significant substantive changes, essentially subjecting partnerships to entity-level taxes.
Even though the centralized partnership audit rules have been in force for six years, now’s a good time to revisit them. That’s because in September 2023, the IRS announced that it would be using some of the funding it received by virtue of the Inflation Reduction Act to focus on partnership compliance. Among other things, the IRS plans to expand its Large Partnership Compliance (LPC) program (which uses artificial intelligence to identify compliance risks) and to leverage compliance letters to target partnerships with balance sheet discrepancies.
A Brief Refresher
In a dramatic departure from prior practice, the centralized partnership audit rules permit the IRS to collect taxes from partnerships rather than from individual partners. They make it easier for the IRS to audit partnerships, by reducing the administrative burdens associated with auditing partnerships. In addition, in many cases, centralized audits increase partnership tax liabilities. Why? Because the IRS determines additional taxes by multiplying the net adjustment by the highest marginal individual or corporate tax rate for the year being audited (the “audit year”). The partnership must account for the resulting “imputed underpayment” in the adjustment year.
By imposing tax at the highest marginal rate, partners may lose the benefit of tax exemptions, lower tax rates, or other partner-level tax attributes that would otherwise reduce their tax liability. However, partnerships will be able to reduce their imputed underpayments by providing the information necessary to establish these tax attributes.
Another burden imposed by the new rules: Since additional taxes are accounted for in the adjustment year, in some cases current partners will be held liable for tax errors that benefited former partners. Partnerships will have two options for avoiding this result:
- Arrange for audit-year partners to file amended returns reporting their distributive shares of partnership adjustments and pay the tax within 270 days; or
- File an election, within 45 days after the audit, to provide audit-year partners with adjusted information returns that will be reflected in their adjustment-year returns.
The centralized audit rules allow certain smaller partnerships (those with 100 or fewer partners that meet certain requirements) to opt out in exchange for assuming additional reporting and disclosure obligations.
Partnerships subject to the centralized audit rules are required to designate a partnership representative (PR) with sole authority to act on the partnership’s behalf in an audit or tax examination. Selection of a PR is critical, as the partners are bound by the PR’s actions. The PR can be any person or entity (including the partnership itself), provided they have a substantial presence in the U.S. If you designate an entity as PR, you must also name an individual (with substantial presence in the U.S.) to act on the entity’s behalf.
Partnerships should work with their tax advisors to evaluate the potential impact of the centralized audit rules and discuss strategies for avoiding harsh consequences.
