Partnerships Remain High on the IRS Radar (Part 1)
July 22, 2020
By Miri Forster
The IRS has released a Bipartisan Budget Act Audit Roadmap, the latest in a series of actions that signal its intention to audit more partnerships. The centralized partnership audit regime enacted under the Bipartisan Budget Act of 2015 (“BBA”) generally applies to all partnerships required to file a Form 1065, U.S. Return of Partnership Income, for 2018 and forward unless the partnership elects out pursuant to Sec. 6221(b).
The BBA is intended to streamline the partnership audit process for the IRS and provide administrative efficiencies by imposing a tax that is assessed and collected at the partnership level. As confirmed by the newly released Audit Roadmap, the BBA reassigns the arduous responsibility of flowing through adjustments to multiple tiers of partners to the partnership and its partners. With pass-through entities in the spotlight, it is essential for partnerships to evaluate their tax reporting and compliance readiness prior to filing.
The BBA Partnership Audit Roadmap
The BBA Audit Roadmap is divided into three stages: (1) Filing/Audit Selection; (2) Audit Process; and (3) Post-Audit. Each stage sets forth specific timeframes for action by the partnership:
- In Stage 1, the IRS issues the partnership a Notice of Selection of Examination letter. The IRS then must wait at least 30 days to deliver a Notice of Administrative Proceeding letter to the partnership. During this 30-day period, the partnership may file an Administrative Adjustment Request (“AAR”) to change the partnership representative (“PR”) designated on Form 1065 as originally filed. During an examination, the PR has sole authority over the partnership and its partners, and its actions are binding even if they conflict with the partnership agreement or state law.
- In Stage 2, the partnership has up to 270 days from receipt of a Notice of Proposed Partnership Adjustment to make a modification request to the IRS to reduce the imputed underpayment shown. The ability to submit a modification request is significant because tax on an imputed underpayment amount is calculated at the highest tax rate for the year under review, which is currently 37%.
- In Stage 3, and within 45 days of receipt of a Notice of Final Partnership Adjustment, the partnership decides whether to elect to push the partnership adjustments out to its reviewed- year partners pursuant to Sec. 6226 or pay the tax at the entity level. Once a push-out election is made, the partnership is no longer liable for the imputed underpayment. Instead, the partnership provides its review-year partners and the IRS with push-out statements reflecting the push-out adjustments. These push-out adjustments are reported by the review- year partner in the year of the adjustment, with interest charged at regular Sec. 6621 underpayment interest rates plus 2%. Partnership adjustments that do not result in an imputed underpayment must be pushed out to reviewed-year partners.
Correcting Previously Filed BBA Partnership Returns
The BBA also incorporates new ways to correct a previously filed partnership return. Under Sec. 6227, corrections are made by filing an Administrative Adjustment Request (“AAR”) on Form 8802. The BBA eliminates the ability to utilize amended Schedule K-1s to reflect partnership adjustments. Instead, the IRS has issued new Form 8985 (Pass-Through Statement Transmittal/Partnership Adjustment Tracking Report), Form 8986 (Partner’s Share of Adjustment[s] to Partnership-Related Items), and Form 8978 (Partner’s Additional Reporting Year Tax) to assist partnerships and partners with fulfilling the new AAR reporting requirements.
A partnership either pays the tax when filing an AAR or pushes the adjustments out to its reviewed- year partners who then report those adjustments and changes to any intervening tax attributes on their tax returns for the adjustment year. Therefore, adjustments are reported in a manner similar to a “true-up,” and partners are not required to amend prior-year tax returns.
Partners that are also partnerships must similarly decide whether to pay the tax at the entity level or push the adjustments out to their reviewed-year partners. To the extent adjustments do not result in an imputed underpayment, the partnership is required to push the AAR adjustments out to review- year partners. Push-out adjustments in the AAR context are subject to regular Sec. 6621 interest rates without the additional 2% charge that applies when a BBA partnership adjustment is pushed out in a BBA examination.
Also significant is that the filing of an AAR under the BBA re-starts the statute of limitations on assessment under Sec. 6235. Therefore, partnerships subject to the BBA are encouraged to file AARs as soon as practicable, once the need for a correction is discovered.
Heightened Focus on Partnership Tax Compliance
The BBA is accompanied by a mandate for increased transparency in partnership tax compliance. In 2019, the IRS introduced significant changes to Forms 1065 and Schedules K-1 (Partner’s Share of Income, Deductions, Credit, etc.) including, but not limited to, the requirement that partnerships report tax capital basis. See IRS Addresses Tax Capital Reporting for 2020 for further details.
Recently, the Treasury and the IRS proposed further updates to partnership tax forms effective for the 2021 tax year that would clarify international tax reporting for partnerships with foreign activities or foreign partners. The IRS is also actively pursuing compliance campaigns focused on pass-thru entities, including the Self-Employment Contributions Act campaign and campaigns focused on sales of a partnership interest and on income deferrals under Sec. 457A.
Check out the companion article: Partnerships Remain High on the IRS Radar (Part 2), which will address recent IRS exam trends. With an escalating focus on partnerships, taxpayers should consider re-examining their structures and tax positions to ensure they are prepared for a rise in IRS activity prior to filing.