New rules that change the way that partnership entities are audited took effect on January 1, 2018. Partnership entities include all entities that are taxed as partnerships under federal tax law, including traditional partnerships (limited and general partnerships) and modern entities that are taxed as partnerships (LLCs, PLLCs, LLPs, and PLLPs). They depart fundamentally from prior rules, by focusing audit adjustments at the partnership level so that the assessment and collection of underpaid tax, penalties, and other additions to tax will now be imposed as a matter of default at the partnership level, rather than at the partner level. This was done in part because of the difficulty the IRS was having auditing large partnerships, which were growing in number, and applying adjustments to myriad partners. Thus the new rules potentially impose partnership-level tax, and they give rise to considerable complexity when considering how to ensure the correct partners ultimately bear the economic burden of adjustments. The new rules are expected to increase substantially the amount of revenue generated by partnership audits.
While the new rules were enacted mainly with large partnerships in mind (where the IRS had the most difficulty imposing audit adjustments at the partner level), they do in fact apply as a matter of default to all partnerships. They tighten up and can have a significant effect on how partnerships with even ten or fewer partners will be treated. They will render certain provisions of many partnership agreements obsolete and will require such agreements to include new language to deal with the new rules. Consequently, all partnerships should examine their partnership documentation to make sure that the new rules are incorporated and dealt with effectively; the cost of doing nothing could be substantial.
Some highlights of the new rules:
The new rules were enacted in the Bipartisan Budget Act of 2015, and their implementation was delayed for two years. They are supported by a voluminous set of regulations. This note is intended merely to touch on some important highlights so you can evaluate the need to prepare for them and, if necessary, update your partnership agreement. It is not equipped to deal with the full complexity of the new rules. However, it is important to understand that the new rules will have to be incorporated and dealt with in the governing document (e.g., partnership agreement or operating agreement) of most entities. For example, partnership agreements that do not already take account of the new rules should be amended to deal with such things as: