Beginning on January 1, 2018, if your business is taxed as a partnership you will need to file an election in order to try and avoid some of the new partnership audit rules. There will be two types of partnerships for audit purposes. The large partnership is one that has 100 partners and assets of $100,000,000 or more. The small business partnership is one that has less than 100 partners. The trap for a small business partnership qualification will be if the business has an ineligible partner, such as a family trust, which is discussed below.
A lot of partnership audit start first with an individual partner’s audit that leads to a partnership audit later. The reason why a business owner would want to file the new election is to avoid a 37% tax on an audit deficiency at the partnership level and be able to push out the deficiency at the partner’s tax level which generally is at a lower tax rate. Audits for 2018 will now be at the partnership level and partners will not be allowed to participate in an IRS audit.
The partnership audit and adjustment rules enacted as part of the Bipartisan Budget Act of 2015 and amended by the Protecting Americans from Tax Hikes Act of 2015 (the “BBA audit rules”) revolutionize the manner in which partnerships will be audited and related taxes will be assessed and collected for tax years generally beginning after December 31, 2017. Beginning in 2018, the TEFRA (Tax Equity and Fiscal Responsibility Act of 1982) partnership audit rules are repealed.
- How do you qualify to be a BBA small partnership? BBA small partnerships are a partnerships with no more than 100 partners of Schedules K-1 and whose partners consist only of one or more of the following five types of partners:
- i) Individuals,
- ii) The estates of deceased partners,
- iii) C corporations,
- iv) Foreign entities that would be C corporations if they were U.S. entities, and
- v) S corporations.
There are three types of ineligible partners for a BBA small partnership. If any partner in the partnership is either a trust, single member LLC, or a partnership they are ineligible partners and will cause the partnership to not be able to make the election. The IRS ruled on January 2, 2018 a typical family trust is an ineligible partner, as well as, other types of trusts that are partners are also a problem.
What can be done if a partnership can’t qualify as a BBA small partnership? If you have an ineligible partner, you need to amend the partnership or operating agreement to provide for the (i) appointment of a “partnership representative” and (ii) a “push-out” provision agreed to by partners. A partnership agreement may “push out” partnership audit liabilities on a pro rata basis to persons who were partners in the reviewed year. While the matter is unclear, it appears probable that these persons may pay their shares of these liabilities at their marginal rate and not at the above 37% rate.
The BBA audit rules are complex and will require all business owners to review their partnership and LLC operating agreements to deal with the new audit rules with their tax advisors. At a minimum, whether or not you can elect to be a BBA small partnership, amending the partnership and or LLC operating agreement to protect the partnership from not having ineligible partners, appointing a “partnership representative” and providing for a “pushout” provision would be a prudent move against potential partnership audits.