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So, the IRS Is Interested in Your Partnership?
The Biden administration proposes to increase the IRS budget by $80 billion over the 10-year period from 2022 through 2031. Part of the increase will be in adding to IRS agents in collections and enforcement. The IRS implemented a new audit regime in 2015, effective for all partnerships starting in 2018, to increase the ease and efficiency of partnership audits for the IRS. Taxpayers should expect the IRS to use some of its growing budget and this relatively new audit tool to examine a higher rate of partnership returns in the years ahead.
Notable Features of the Centralized Partnership Audit Regime (CPAR)
- By default, partnerships are subject to tax on positive (unfavorable) IRS audit adjustments.
- Partnerships can no longer voluntarily amend their returns but must instead file an administrative adjustment request (AAR).
- The tax rate applied to positive audit or AAR adjustments is the highest individual (or corporate, if higher) income tax rate in effect for the reviewed tax year. The partnership may request a modification to the tax rate in certain circumstances, e.g., the partnership has a C corporation partner that is subject to the lower 21 percent rate.
- In lieu of paying the tax, the partnership can elect to push out the positive adjustments to the partners in the reviewed year (tax year being adjusted). Negative adjustments (taxpayer favorable) must be pushed out in the case of an AAR. Negative adjustments related to an IRS audit generally default to being reported on the partnership return for the year the exam is closed or in some cases may be pushed out to the reviewed year partners.
- The partners would be responsible for paying any tax due with respect to the adjustments with their income tax returns for the adjustment year (year the partner receives the pushout statement).
- Under current law, a net reduction in tax for the reviewed year partners due to negative adjustments is treated as a nonrefundable credit on the adjustment year tax return.
- Current partners may incur the economic burden of an entity-level assessment related to an earlier year with different partners or ownership.
Example of CPAR at Work
For taxable years 2019 through 2021, Elsinore, LLC (taxed as a partnership) has two equal members, Laertes and Ophelia. The IRS examines the 2019 return and determines the $100 ordinary loss allocated equally to Laertes and Ophelia should instead have been allocated solely to Laertes. The IRS issues its final partnership adjustment on March 1, 2021—an increase in 2019 ordinary loss allocated to Laertes of $50 (negative adjustment) and a decrease in 2019 ordinary loss allocated to Ophelia of $50 (positive adjustment). The positive adjustment is multiplied by the highest income tax rate (assume 40 percent), resulting in a $20 imputed underpayment that would be owed by the partnership. Because the entire negative $50 adjustment should have been allocated to Laertes, and since Laertes also was a partner in the reviewed year, the adjustment is taken into account by Elsinore, LLC by allocating the entire negative adjustment to Laertes on its 2021 tax return.
Note: 2019 is the “reviewed year” and 2021 is the “adjustment year.”
Decision Point 1: Assume Polonius is the partnership representative. He would have an opportunity to modify the imputed underpayment prior to the issuance of the final partnership adjustment. For example, Polonius could request a modification in tax rate if Ophelia is a C corp taxed at 21 percent.
Decision Point 2: Once the IRS issues the final partnership adjustment, Polonius also would have the discretion to choose whether the partnership or the partner pays the tax on the imputed underpayment. Let’s say Hamlet purchases Ophelia’s interest in 2020. Polonius could elect to push out the positive adjustment to Ophelia. Ophelia would then recompute her 2019 income tax with the push-out adjustment and pay the additional tax due with her 2021 income tax return (or may pay sooner).
Some Partnerships May Elect Out
By default, the CPAR applies to all partnerships after 2017. Partnerships with 100 or fewer K-1s may elect out of the CPAR but only if all partners are individuals, corporations, estates of deceased partners, or foreign entities that would be treated as C corps if domestic. Disregarded entities (such as single-member LLCs and grantor trusts), trusts, and partnerships are not eligible partners and prevent a partnership from opting out. Each shareholder of an S corporation is counted as one qualified partner for the 100-partner test.
CPAR Pros & Cons
- Administrative Burden – The CPAR generally limits the need for separate partner action; the overall administrative burden stays with the partnership. Alternatively, imagine numerous partners perhaps in numerous geographic locations responding to IRS information requests. Partnership decision makers may not want to introduce such complexity for company owners.
- One Individual Represents the Partnership – One person, the designated partnership representative, handles communication with the IRS. He or she has the sole responsibility to correspond with the IRS and thereby has the only direct effect on the audit, its pace, and ultimate resolution. The designated partnership representative’s actions are binding on the partnership.
- Focus of Audit Is the Partnership – Partner returns are generally not pulled into the CPAR audit.
- Tax Rate Defaults to Highest Income Tax Rate – As mentioned above, the partnership representative may provide certain information to the IRS to reduce the imputed underpayment or applicable tax rate. In addition, unfavorable adjustments may be pushed out to partners, but the underpayment is subject to a higher interest rate (+2 percent).
- Negative Adjustments May Result in Nonrefundable Credit – Partners may lose the tax benefit of a negative adjustment if their adjustment year tax is less than the nonrefundable credit amount.
Partner-Level Pros & Cons
- Administrative Burden – Partner receives separate notices of deficiency, negotiates separate settlements with the IRS, and elevates court challenges separately. The partnership, being the source of relevant books and records, potentially fields more questions and numerous document/information requests. (Counterpoint: a large and geographically diverse partner base increases the burden on the IRS, perhaps leveling the playing field.)
- Each Partner Has Control over Audit – Partners may desire direct involvement in IRS audits. Also, there may be perceived conflicts of interest on the part of a partnership representative under CPAR.
- Focus of Audit Is the Partner – The partner is the target of the audit and tax assessments. Partners’ personal returns are included in the audit, which means scrutiny on tax items not related to partnership operations.
- Possible Inconsistent Results – Each partner may face different tax outcomes because of separate notices of deficiency, settlements, or court decisions.
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