Kevin F. Howley, CPA, Partner
Michael D. Koppel, CPA, PFS, CITP, MBA, Retired Partner
Gray, Gray & Gray, LLP
If your architectural or engineering firm is organized as a partnership (or LLC taxed as a partnership) there are new rules you should be aware of concerning potential IRS audits. The changes were made to increase the number of audits the IRS can conduct by decreasing the time required to conduct each audit.
The first change is the creation of a designated “taxpayer representative” for each partnership, replacing the old “tax matters partner.” The taxpayer representative has a much more important role. Partners other than the taxpayer representative no longer have the right to participate in a partnership audit or judicial proceeding. Partners will not even be notified by the IRS that the partnership is being audited and will not be able assist in the partnership’s defense. In addition, the taxpayer representative will be the one to inform the IRS if any of the elections (discussed below) will be used in case of an IRS audit.
A lot of responsibility falls on the shoulders of the taxpayer representative, who does not even have to be a partner. This makes the selection of the taxpayer representative a weighty choice. We suggest that partnership agreements should be rewritten to indicate who will serve as the taxpayer representative, how the individual can be removed, and how a new taxpayer representative will be determined.
The changes to the audit process itself are even more significant. Under the new rules any changes determined in the course of an audit of a partnership by the IRS, including penalties or additional taxes, will be made at the partnership level. Furthermore, the tax will be calculated at the highest marginal rate for individuals or corporations. Any changes will be assessed to the partnership in the year the audit (or subsequent judicial review) is completed. In practice this could burden current partners with fiduciary responsibility for audits of prior years, even if they were not a partner at that time.
If you’d prefer not to face this possibility, there is an “out” available. The new rules will be effective unless a partnership elects one of these exceptions:
- Small partnerships: If you have 100 or fewer partners you can make a “small partnership” election. In order to qualify the partners can only be (i) individuals, (ii) estates, (iii) C corporations, (iv) S corporations, and (v) foreign entities that would be C corporations if they were domestic entity. That means if any of the partners are trusts (including a revocable grant trust), a single member LLC, or another partnership (i.e. tiered partnerships), your partnership is not eligible. You must make the small partnership election on a timely filed return and include information regarding all partners on a new form. We recommended that the partnership agreement be amended to indicate whether a qualifying partnership is going to make this election.
- Push-out election: A partnership can elect out of the new audit rules, but must also send amended K-1s to all former partners. Note that the partnership, not the IRS, must send out the amended K-1s. Partnerships wishing to make this election must do so with 45 days of receipt of the notice of a partnership adjustment. To avoid any misunderstandings by the taxpayer representative we believe the partnership agreement should be amended if the push-out elect out election is desired.
- Rate adjustment: As indicated, the IRS will assess any additional tax at the highest corporate or individual rate. The taxpayer representative will be given an opportunity to try and demonstrate to the IRS that some or all of the assessment should be at a lower rate.
This article is only an overview of the new partnership audit rules. If you have any questions regarding how the new rules might affect your architectural or engineering firm, what you should do if your partnership is audited, and what changes to your partnership agreements would be appropriate, please contact our Tax Department at (781) 407-0300.