Are You a Partner in a Partnership?

Are You a Partner in a Partnership?

Are you a partner in a partnership? Does your partnership have a designated representative? Do you understand how your partnership is taxed in an audit? These are important questions we will address in this article.

In general, partnership income and gain are not taxed at the partnership level but flows through to the partners personal tax return and taxed at their level. The IRS passed new audit rules a few years ago which created one of the rare situations in which federal tax may be assessed directly to the partnership at its level. These new rules, known as the centralized partnership audit regime, were part of the Bipartisan Budget Act of 2015 (BBP) and affect partnerships with tax years beginning after December 31, 2017. The new centralized partnership audit regime rules are effective for any tax year beginning from 2018 or later. The new audit rules apply to any partnership required to file a federal partnership return unless the partnership is eligible to elect to opt out and chooses to exercise that election. For partnerships that fall under the new audit regime, any assessment of additional tax, income, or loss will be assessed at the partnership level. This means that any tax resulting from an adjustment assessed by the IRS is calculated based on the highest individual tax rate which is 37% for 2020, even if all the partners’ individual rates are significantly lower. The partnership must also select a partnership representative. Under the new audit rules, this designated representative has complete authority with respect to acting for the partnership under audit. The partnership representative should be designated each year on Form 1065 and filed with the IRS. The IRS can designate any partner it chooses if the partnership does not designate a representative on the tax return.

Because of the reasons noted above, most ADKF clients choose to opt out when we present the option and background each year. Partnerships are eligible to opt out under Code Sec. (b) if they have fewer than 100 partners and all partners are eligible, meaning all partners are individuals, C-corporations, foreign companies that would be treated as C-corps if they were US companies, S-Corporations, and the estates of deceased partners. A partnership with any other type of partner would not be eligible to make the election to opt out of the new audit rules.

The election must be made with a timely filed Form 1065 for each year that the partnership wishes to opt out of the new audit rules. The election is made by completing and attaching Schedule B-2 to the federal return, and partners must be notified of the election by the partnership. If an eligible partnership opts out of the new centralized partnership audit regime rules, then audits will be conducted under the rules applicable to the individual partners, meaning the audit will be taxed to the individual partners and not to the partnership at the highest individual rate. There are a couple of special rules to consider relating to S-Corporation partners under the treasury regulations. The shareholders of any S-Corporation that is a partner in the partnership must also be counted towards the 100- partner limit. When electing to opt-out of the partnership audit regime, the partnership must report the name, taxpayer identification number, and federal entity type for the shareholders of the S-Corporation partner.

When clients want to form new partnerships or our clients are considering adding new partners to an existing partnership, ADKF  advises clients on potential impacts these transactions could have on a partnerships eligibility to opt out of the partnership audit rules, bearing in mind that the partners in a partnership that do not or cannot opt out, will likely be subject to higher tax rates than a client that can opt out in the event that the IRS ever assesses an audit adjustment on the partnership. For our clients who are planning to acquire in interest in an existing partnership, we will also advise them if the partnership is eligible to opt out. If it is not, the new partner could be on the hook for audits conducted for a prior year when the partnership had not elected to opt out where taxes would be assessed to the partnership at the highest individual rate. If you have questions or want to understand more about the tax effects and tax provisions of your partnership agreement, we are here to help. Make an appointment today.

is the largest, locally owned public accounting firm in San Antonio, Texas, with branch offices in Boerne and New Braunfels. We have been serving our community since 1991. We are a full-service CPA firm dedicated to providing a broad range of tax, audit, bookkeeping, tax controversy, and consulting services with superior customer service to help our clients meet their goals and objectives. Please click here to set an appointment with us.

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