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Recently I had a California client that was being pursued for non-filed CA returns on a Nevada Partnership with significant assets in California. California real estate, California Property Management Company and California partners. California levied against the partnership assets potentially showing California early adoption of the federal changes.
It has been something of a long-held dirty secret for the IRS that its ability to audit partnerships has been severely lacking. The agency has endeavored and audited under the same audit rules for more than 30 years since they were drafted back in 1982. As such, they were probably long overdue for a significant overhaul. However, changes in the national economy – perhaps motivated by individuals realizing that IRS partnership audit protocols were lacking – have resulted in a trend towards selection of the partnership entity. In 2012, there were more than $7.5 trillion in assets held by large partnerships of more than 100 members. Furthermore, two-thirds of large partnerships have more than 1000 direct or indirect partners.
Thus, it has been clear that for a number of years that the IRS was not effectively examining or auditing partnerships. However, new rules that make a fundamental break with the traditional handling of partnerships have been passed as part of the Bipartisan Budget Act that became law on November 2, 2015 with President Obama’s signature. This new handling of partnerships will undoubtedly result in significantly more stringent review of filings and requires existing partnerships to consider how the new rules will affect the economic arrangement.
Traditional tax treatment of a partnership requires pass-through handling of the entity. While pass through entities can be particularly complex and difficult to understand and pierce, the underlying concept is relatively straightforward. The partnership entity itself was previously not subject to federal tax. Rather, the entity’s losses, gains, and other financials are passed through to the partners per the terms of the partnership agreement. The partners then file their own personal taxes and are supposed to pay any assigned tax liability incurred through the partnership. This system was causing excessive difficulties for the IRS resulting in an abysmal audit rate for partnerships that one GAO study pegged at just .08 percent of partnerships.
Under the new rules, a number of changes would be made regarding the handling of partnerships and the IRS’s powers during a tax audit. To begin with, under the new rules the IRS is permitted to conduct an audit at the partnership level rather than auditing each and every partner and then attempting to glean a comprehensive picture from these component parts of the entity. Furthermore, if a tax deficiency is detected during an audit, the partnership entity itself will be able to be held liable for the unpaid tax debt. Audit rates should increase under the new rules.
Aside from these changes, individual partners will lose at least some of their current ability to affect change in the audit process. This is because individual partners are no longer audited. Rather, the audit of the partnership itself is administered by a “partnership representative.” Actions taken by the representative are likely to bind partners and reduce the options they may have moving forward.
The good news is that the new partnership rules do not go into effect until the 2018 tax year. This means that there is still ample time to engage in careful analysis as to how these changes may affect your entity. Furthermore, most partnerships of 100 or fewer partners will have the option to opt-out of the new rules provided that all of the partners are individuals, C corporations, S corporations or estates of deceased partners. Furthermore, partnerships that are investment funds with other partnership investors are ineligible to opt-out. Other qualifying partnerships may choose to issue adjusted Schedule K-1’s to all partners within forty-five days thus making each member of the partnership responsible for the corresponding amount of tax deficiency.
Even if opting out of the new rules is not possible due to the entity size, structure, or for other reasons the new rules provide for a number of opportunities to reduce the amount of tax owed. An experienced tax attorney can provide on-point guidance about how certain assumptions, exemptions, and allotments in the new law can create a more favorable tax treatment for a large partnership.
While the new legislation will not take effect for a number of years, the time to start planning for these changes is now. Existing partnerships must consider how these new rules will affect the entity and if opting out is a viable alternative. Furthermore, individuals in negotiations to create a new partnership should consider these changes at the outset of entity formation. The experience CPAs and tax lawyers of the Tax Law Offices of David W. Klasing can provide individualized, strategic guidance regarding business entity tax planning. To schedule a reduced-rate consultation with an experienced attorney call 800-681-1295 or contact us online today.