Partnership Tax Audits: New Audit Regime Allows IRS to Assess and Collect Tax at the Partnership Level

Sullivan & Cromwell LLP - November 5, 2015

The Bipartisan Budget Act of 2015 (the Budget Act) replaces the current partnership audit procedures with a very different procedural regime. Under the current procedures, the Internal Revenue Service (IRS) audits partnerships at the partnership level, but the IRS is required to flow any audit adjustments through to the partners who are ultimately liable for any tax due. According to IRS Commissioner John Koskinen, inefficiencies in the current partnership audit procedures make the process very difficult for the IRS. For these reasons, the Commissioner has stated that the IRS audits very few large partnerships.

Under the new regime, the default rule provides that the IRS will assess and collect tax, penalties, and interest attributable to audit adjustments at the partnership level instead of the partner level. To avoid that result, a partnership can elect to pass the liability to the partners during the tax year to which the IRS adjustment relates. While this alternative procedure achieves a similar result as the current partnership audit procedures, the key difference is that the partnership rather than the IRS must determine how to flow the audit adjustments through to its partners, and the partnership must report these adjustments to its partners and the IRS.

The new partnership audit procedures are effective for tax years beginning on or after January 1, 2018, although partnerships may elect to apply the provisions sooner. The procedures are intended to reduce the IRS’s difficulty in auditing partnerships, which should in turn increase both the number of partnership audits and the amount the IRS ultimately collects from those audits. The Congressional Joint Committee on Taxation estimates that this change in audit procedures will result in approximately $9.3 billion in additional revenue over ten years. The new procedures likely will also affect the way future partnership agreements are drafted and negotiated.