Beginning in tax year 2018, real estate partnerships will see a shift in how the IRS performs their audits. With the passage of the Bipartisan Budget Act of 2015, Congress repealed the existing audit procedures and replaced it with a new regime that will apply to all partnerships beginning in tax year 2018.
Changes to Expect
Under the old audit rules, any unpaid taxes exposed by an IRS audit would be assessed on the partners directly. If partnership ownership had changed over the years, previous owners would be subject to audit adjustments made to the partnership’s reportable income and expenses for years that they were owners. Under the new audit regime, that all changed; the partnership itself will now be the party responsible for covering the unpaid taxes and handling the assessed penalties and interest. Certain types of partnerships can opt out of the new audit rules, but partnerships with over 100 owners, or partnerships that have certain entities as owners, are unable to elect out.
Impact of these Changes
The biggest impact that real estate partnerships can expect from these new rules will be that the partnership will be responsible for paying any unpaid tax; this means that the current partners will be required to absorb the financial impact of the audit, even if the changes should have impacted a previous partner.
Additionally, the tax, penalties, and interest that are assessed on the partnership will almost certainly be higher than if the tax, penalties, and interest had been calculated for each individual partner. The taxes resulting from the audit adjustments are calculated using the highest individual income tax rate, regardless of income characterization, and regardless of the individual partners’ tax rates applicable for that tax year.
Partnerships will also be required to appoint a “partnership representative” each year. The partnership representative will perform the role that the “tax matters partner” performed in the past, but with more responsibilities. The partnership representative will be the point of contact for the IRS auditors and has the power to bind the other partners to a decision made during the audit.
The IRS recently released proposed regulations that, if passed, may alleviate the frustrations that many real estate partnerships are experiencing from these new rules. In these proposed regulations, there is the option to use a “pushout election” to drive the tax liability down through the tiers of the partnership to the ultimate individual or corporation responsible. These tiered pushouts shift the burden of calculating the taxpayer responsibility from the IRS to the partnership and its owners. There will be some reporting requirements, and it will be up to the partners to determine if the effort of doing the calculations will outweigh the simplicity of having the partnership bear the brunt of the tax.
Even though the new audit regime has been written into the tax law, the IRS has not yet finalized the regulations that interpret this law. The proposed regulations that introduced the pushout elections are not yet binding, but viewing them can be helpful; they let taxpayers know the IRS’s intentions for interpreting the law.
To prepare for this change, partnerships can do a few things. First, they can update the partnership agreement. The new agreement should address (1) the process of electing and modifying the partnership representative, (2) whether or not the partners will reimburse the partnership for the imputed underpayment, and (3) whether or not pushout elections will be used, and how they will be calculated. Second, taxpayers can take this opportunity to scrutinize their partnership allocations. Complex allocations can be burdensome for the partnership should they elect into pushout elections, and they can invite the IRS to issue audit adjustments on incorrect allocations, something that the IRS has often previously overlooked when the calculation would be too time-consuming.
There are significant changes to the IRS audit regime regulations which will impact real estate partnerships. Since the changes are complex, it’s important to work with a qualified advisor who can help guide you through the process. If you would like additional information on the changes or need assistance with a tax, audit or accounting issue, Hanson & Co can help. For additional information please call us at 303-388-1010 or click here to contact us. We look forward to speaking with you soon.