In November 2015, as part of the Bipartisan Budget Act (BBA) of 2015, Congress enacted a new centralized partnership audit regime to replace the TEFRA partnership rules. The new partnership audit regime applies to all partnerships and, like TEFRA, IRS examinations and adjustments will be made at the partnership level. However, unlike TEFRA, the IRS will assess and collect tax from the partnership.
The new centralized partnership audit regime is generally effective for partnership tax years beginning after December 31, 2017. As a result, the 2018 tax returns for most partnerships will be the first tax return filed under the new regime. In a prior blog post (HERE), we discussed the issues related to the designation of a partnership representative on the 2018 tax return. In this blog post, we will discuss the how and when a partnership can elect to opt out of the new centralized partnership audit regime.
For 2018, a partnership that is eligible to opt out of the new centralized partnership audit regime may do so by answering “yes” on Form 1065, Schedule B, line 25 and completing the new Schedule B-2 (Here). Pursuant to IRC Section 6221(b) a partnership is eligible to opt out if:
- The partnership elects out for such taxable year on a timely filed tax return;
- For such taxable year, the partnership is required to furnish 100 or fewer statements under Section 6031(b) with respect to its partners (i.e., Schedule K-1s);
- Each of the partners of such partnership is an individual, a C corporation, any foreign entity that would be treated as a C corporation were it domestic, an S corporation, or an estate of a deceased partner; and
- The partnership notifies the partners of such election within 30 days of making the election.
A partnership is not eligible to make an opt out election if any of its partners are trusts, partnerships, non-C corporate foreign entities, disregarded entities, nominees or estates of non-deceased individual.
For purposes of applying the 100 partner rule, a Schedule K-1 issued to one spouse owning a community property interest in the partnership is considered as one Schedule K-1. If both spouses each own a community property interest and receive separate Schedules K-1, then the number of Schedules K-1 for this purpose is two. In addition, the Schedules K-1s an S corporation is required to furnish to its shareholders are treated as statements furnished by the partnership for purposes of applying the 100 partner rule.
An opt out election is binding unless the IRS determines the election is invalid. Thus, even an undisputedly invalid election remains binding until the IRS determines the election is invalid. There is no guidance regarding the time frame for the IRS to determine if the election is invalid.
Schedule B-2 requires a partnership that has made an opt out election to disclose the name and taxpayer identification number of every partner to the IRS. For any partner that is an S corporation, the partnership must disclose the name and taxpayer identification number of each S corporation shareholder for the taxable year of the S corporation ending with or within the partnership taxable year for which the election to opt out is made.
If a partnership makes an opt out election, IRS audit, deficiency, assessment and collection proceedings are conducted at the partner level. As a result, the IRS will have to open a separate audit for each partner. Moreover, each partner will be able to litigate the adjustments against him/her/it separately, maybe in different courts, which could result in inconsistent determinations on identical issues. And certainly, the situation would be ripe for different settlements between any one partner and the IRS. In addition, an audit at the partner level will require the partnership’s cooperation in providing information and documentation. Failure to do so could be very detrimental to a partner. The partners should consider amending their partnership agreement to include language requiring the partnership to cooperate in a partner-level audit or audits.
For any questions on this or any other tax-related matter, please feel free to contact Joel Crouch at (214) 749-2456 or firstname.lastname@example.org.