“Give me six hours to chop down a tree and I will spend the first four sharpening the axe.”
― Abraham Lincoln
The Bipartisan Budget Act (BBA) was signed into law by President Barack Obama in 2015 and fundamentally changed the way partnerships are audited. Under the BBA, the IRS generally assesses and collects any understatement of tax (called an imputed underpayment) at the partnership level. The new rules were applicable to all entities starting on January 1, 2018, unless they are eligible to elect out. A significant uptick in BBA audits hasn’t, for the most part, occurred because of other demands on the IRS. However, a ramp up in BBA audits in 2021 is expected given IRS plans to increase audits on small businesses, usually operating as partnerships, by 50 percent. Preparation prior to any audit is a good idea, but it is imperative for partnerships navigating new audit rules under BBA. Here are some ways to sharpen your axe before the audit notice arrives.
Elect out of BBA Rules
Tax advisors are almost uniform in their guidance that if a partnership can elect out of the new rules they should do so. This election must be made each year on the original IRS Form 1065 and, unless revoked or invalid, puts the partnership under general deficiency audit procedures. In general, partnerships with 100 or fewer partners for the taxable year can elect out of the BBA audit rules if all partners are eligible partners. Ineligible partners include partnerships, trusts, foreign entities that would not be treated as a C corporation were it a domestic entity, disregarded entities, estates of individuals other than deceased partners and, people who hold an interest in the partnership on behalf of another person. Partnerships should review their structure to see if election out of the BBA rules is possible and, if not, if changes are worth making to elect out in future years.
Consider the Authority of the Partnership Representative
To streamline the audit process the IRS requires designation of a Partnership Representative (PR) as the sole person the IRS will contact and deal with during the audit. Partners must consider the PR designation carefully to ensure the proper person will be communicating exclusively with the IRS. Equally important is providing clear guidance, in the partnership agreement, of the notice that must be provided to other partners and any limitations on the duties of the PR. If the other partners of a partnership want information, or an opportunity to discuss and determine a course of action that occurs during the audit, then it should be outlined in the partnership agreement. For example, if an audit results in amounts owed that payment can be paid by the partnership or “pushed out” to the partners. That decision may not always be communicated to those impacted if such notice isn’t required or authority limited by the agreement. Questions about how certain provisions will operate during, or after, an IRS audit should be discussed with a tax professional.
Consider Potential Changes in the Partnership Carefully
As indicated above, a partnership elects out of the BBA audit rules annually. Therefore, potential changes in the partners must be evaluated to determine if it will prevent election for that year. Also, any corrections to a partnership’s tax return must be made as an Administrative Adjustment Request (AAR), which can only be filed by the Partnership Representative. Any AAR must calculate whether the requested adjustments result in an imputed underpayment (IU) and, if so, must report that IU. The IU must be paid by the partnership or “pushed out” to partners who calculate, report and pay the corresponding amounts. Therefore, any change to correct a mistake or to benefit the partnership must also consider the potential impact if audited.
Partnerships are a popular and flexible choice for taxpayers to use in operating their businesses. However, they come with their own unique challenges when complying with the tax laws and BBA audit rules. Once an audit starts is an unfortunate time to realize certain challenges weren’t considered. A review of current partnership agreement terms will help ensure proper protections are in place if audited. Considering the tax impact of changes in the partnership, as they occur, will also help keep a partnership’s axe sharp and ready for any potential IRS audit.