IRS Commissioner Charles Rettig and many Democrats in Congress have called for additional IRS funding to aid in enforcement of the nation’s tax laws. It is not yet clear whether the Build Back Better plan currently working its way through Congress will include such funding. That does not mean that all is quiet on the IRS enforcement front. The IRS is on the verge of a major enforcement initiative authorized by Congress that will affect partnerships and their partners.
Centralized Partnership Audit Regime
In 2015, Congress passed the Bipartisan Budget Act of 2015 which, among other things, established a new centralized audit regime for partnerships. The IRS implements that program through its Large Business and International (LB&I) Division, which allows the IRS to audit partnerships and impose tax on the partnership as an entity. The partnership generally can elect to pay this entity-level tax that results from examination adjustments, or it can elect to “push out” the tax to its partners who would then be liable for their share of the tax.
If the partnership elects to pay the tax at the entity level, then it is calculated at the highest income tax rate (currently 37%, which pertains to individuals). It does not matter whether the constitution of partners may all be subject to a lower maximum rate, such as 21% in the case of corporations. When the partnership follows the default rule, the entity-level tax is due in the year the examination is completed. This means that the current partners will bear the economic burden of the tax, even if they were not partners during the year under examination. Small partnerships (fewer than 100 partners and meeting certain other requirements) can elect out of the centralized partnership audit regime, but this is not always advisable because IRS examination activity will be expanded to include each partner’s entire return, instead of focusing solely on partnership items.
These centralized partnership audit regime went into effect for tax years beginning after Dec. 31, 2017. But the IRS does not commence audits immediately, especially in cases where the rules are new and the subjects of the examinations involve large and often complex business entities.
IRS Audit Activity for Partnerships to Increase
Although IRS examination activity for partnerships under the new regime did not immediately get underway, additional activity is on the immediate horizon. Clifford Scherwinski of the IRS LB&I division recently stated, “[T]hese returns are in fact being assigned, and we expect the audit work to begin in early fiscal 2022 — which, for those of you who are paying attention, starts in October, so very, very soon.” Thus, taxpayers and tax professionals may be seeing IRS notices or receiving other IRS communications regarding audits of their partnerships in the very near future.
Other IRS Enforcement Initiatives affecting Partners and Partnerships
It is not just partnership returns that taxpayers will have to worry about, though. The IRS can also use the separate global high-wealth program, also run by the IRS LB&I division, as a jumping off point to examine the individual and business returns of partners. This can include taxpayers who are connected to a partnership but who don’t have an official ownership interest. The global high-wealth program includes a database that tracks how income and other tax attributes, such as deductions or credits flows from the partnership return to other tax returns including S corporation tax returns, other partnership returns, and ultimately the individual income tax returns of the ultimate owners. Under the high-wealth program, the IRS is looking for “large, unusual, and questionable” items not just on the examination target’s return but also on those taxpayers who may be indirectly influenced by the target.
The global high-wealth program generally targets taxpayers with foreign assets or foreign financial accounts, while the centralized audit regime targets the partnership entity.
But these initiatives are not the only way that partners, and their partnerships, can be swept into the IRS audit machine. The IRS currently also has a “high-income” initiative. This program, which is a joint venture between the LB&I division and the Small Business/Self-Employed Division (SB/SE), focuses on “high-income” taxpayers who have at least one related entity such as a partnership or S corporation. “High-income” for purposes of the program is not explicitly defined, but the IRS has made it clear in other contexts, such as pursuit of non-filers, that high-income may be as little as $200,000 of income per year. This means that the high-income initiative provides the IRS an additional broad avenue to inspect the returns of partners and their partnerships.
The centralized partnership audit program’s first audits will be rolling out very shortly. This means that taxpayers and tax professionals should be prepared to respond to any IRS notices or correspondence quickly and completely. The partnership representative (PR) is the only person with whom the IRS is authorized to conduct an examination, though the PR may separately authorize a CPA, enrolled agent, or an attorney to assist with an IRS examination. The PR for any given year is identified on the partnership’s originally-filed return, and can be replaced once the partnership receives IRS notification that it will be audited.
In any case, partnerships confronted with an IRS examination should seek the help of a tax professional to ensure the process runs efficiently and to help the PR make optimal decisions throughout the audit process. Should you have questions about the partnership audit process or if you receive a notification that your partnership will be audited, please contact us.
Published on October 06, 2021