IRS Partnership Audit Rules: What You Need to Know

Are you prepared for the potential impact of the IRS partnership audit rules on your business? If not, you're not alone. Many business owners remain unaware of how the Internal Revenue Service (IRS) can alter their financial landscape, especially since significant changes to the partnership audit rules went into effect in 2018. These rules were introduced as part of the Bipartisan Budget Act (BBA) of 2015 and fundamentally changed how partnerships are audited and taxed. The rules shifted liability for audit adjustments from individual partners to the partnership itself, potentially leading to substantial consequences if a business isn't prepared. Here's a deep dive into what you need to know.

The Partnership Audit Landscape: What Changed?

Under the new IRS partnership audit rules, gone are the days when individual partners would shoulder the responsibility for audit adjustments. Previously, if the IRS audited a partnership, it would make adjustments at the partner level, meaning each partner would be responsible for their portion of any underpayment. Now, under the BBA rules, the partnership entity itself is responsible for the payment of any tax underpayment discovered during an audit.

Why is this important?

If you're running a partnership, this means that the entity could be required to pay taxes on behalf of past or even future partners—whether they still have a stake in the business or not. The rule significantly centralizes the process but also opens the door to complications, especially for partnerships that have gone through changes in ownership.

A Real-World Example:

Let’s say your partnership is audited for tax year 2020 in 2023. During the audit, the IRS finds a substantial underpayment. Under the old rules, each partner as of 2020 would be liable for their share. But under the new rules, the partnership as it exists in 2023 is responsible for paying the tax—even if the partners in 2020 are no longer involved in the business. This can create real challenges for managing capital and cash flow.

How Can a Partnership Respond to an IRS Audit?

The IRS partnership audit rules provide several options for partnerships when they are audited:

1. Pay the imputed underpayment at the partnership level: The default option is for the partnership to pay any tax underpayments at the entity level. This can be particularly beneficial if it's easier for the partnership to settle the bill rather than chasing down former partners.

2. Electing out: Certain small partnerships can elect out of the centralized audit regime if they meet specific criteria, such as having fewer than 100 partners. If the partnership qualifies, the audit can proceed at the individual partner level as it did under the old rules.

3. Push-out election: Another option for partnerships is the "push-out" election. With this election, the partnership can push the liability down to the partners who were part of the business during the audited year. This can help to allocate the responsibility appropriately but can be an administrative headache.

The Importance of the Partnership Representative

A key component of the IRS partnership audit rules is the designation of a Partnership Representative (PR). Under the BBA rules, this individual has the sole authority to interact with the IRS on behalf of the partnership. The PR doesn’t need to be a partner but should be someone who is well-versed in tax law and familiar with the partnership’s financial and operational structure.

The Partnership Representative's decisions during an audit are binding on the partnership and its partners, so choosing the right person for this role is critical. The wrong choice could mean making decisions that aren't in the best interests of all partners, particularly in cases where there’s a disagreement about how to handle an audit adjustment.

Challenges for Changing Partnerships

One of the main issues with the new IRS partnership audit rules is the potential for financial inequities when partnerships undergo ownership changes.

Consider this scenario:

• You are a partner in a profitable real estate partnership.
• In 2019, you sell your share of the partnership to a new partner.
• Fast forward to 2024—the IRS audits the partnership for tax year 2018 and discovers a significant underpayment.

Under the new rules, even though you are no longer a partner, the partnership (with its current partners) is responsible for paying the underpayment. The new partners who weren’t part of the partnership in 2018 might end up covering the cost of the tax bill for your former share. This situation can lead to unfair financial responsibilities for the current partners, and it's something every partnership should consider when managing ownership transitions.

Practical Steps for Partnerships to Prepare for an Audit

1. Review and Update Partnership Agreements
One of the most crucial things you can do to prepare for the IRS partnership audit rules is to review and update your partnership agreement. Many older agreements may not reflect the new centralized audit regime. Consider adding clauses that address how the partnership will handle audit adjustments, tax liabilities, and whether the partnership will opt for the push-out election.

2. Elect the Right Partnership Representative
Choosing the right PR is essential. You need someone who can manage the complexity of an IRS audit and negotiate the best possible outcome for the partnership. Ideally, this person should have a background in tax law or at least work closely with a competent tax professional.

3. Assess Partner Turnover
If your partnership has a high turnover rate, you should have a strategy in place for dealing with potential audit liabilities that could arise after partners leave. Address these issues in the partnership agreement to avoid confusion and disputes down the road.

4. Consider Tax Liability Insurance
Given the increased responsibility on the partnership itself, some businesses are turning to tax liability insurance as a way to protect themselves. This insurance can help cover the cost of an audit adjustment, reducing the financial burden on the partnership and its partners.

Understanding the Imputed Underpayment

An imputed underpayment is the tax the IRS determines is owed after an audit, based on adjustments made to the partnership's income, deductions, or credits. It is calculated by applying the highest statutory tax rate to the adjustment amount, which can sometimes lead to overpayments if the individual partners are in lower tax brackets. However, the IRS allows partnerships to adjust the imputed underpayment by providing proof that specific partners are eligible for lower rates or tax exemptions.

This process can be time-consuming and requires careful record-keeping. Partnerships need to maintain detailed documentation of partner information and the tax attributes of each partner to make these adjustments. Without proper records, the partnership might end up overpaying the imputed underpayment.

Final Thoughts: Are You Ready for an IRS Partnership Audit?

Navigating the IRS partnership audit rules is complex, and understanding these regulations is crucial to protect your business. The centralized nature of the audit process means that partnerships can no longer rely on individual partners to handle their own tax liabilities. The potential impact on cash flow, equity, and partner relations cannot be understated.

By taking proactive steps like updating partnership agreements, selecting a qualified Partnership Representative, and preparing for potential audits with good record-keeping and tax planning, your business can avoid many of the pitfalls associated with the new rules. It’s better to be over-prepared than caught off guard when the IRS comes knocking.