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The Centralized Partnership Audit Rules (CPAR) were enacted by the Bipartisan Budget Act of 2015, P.L. 114-74, and amended by Protecting Americans From Tax Hikes Act of 2015, P.L. 114-113. These new rules will apply to the audits of partnership tax returns filing after December 31, 2017. One of the purposes of the new rules was to enhance the ability of the IRS to audit partnerships at the partnership level, i.e. have the partnership pay any additional taxes instead of the partners separately. While it might seem convenient for both the IRS and the partnership to only adjust one return, having the adjustment at the partnership level is often the worst-case scenario.
The CPAR is now the current default audit procedure for partnerships unless the partnership elects out. If a partnership does not elect out of CPAR, there are some important considerations and consequences that the taxpayers should know. One such consideration is that a partnership may end up paying the tax for a year when it has different partners.
Under CPAR an adjustment that increases the tax liability creates an Imputed Underpayment (IU) which the partnership must pay. The tax rate is at the highest tax rate and does not take into consideration any tax items from the partners (e.g., net operating losses and passive activity losses). To make matters worse, the tax payments do not increase the partner’s outside basis of the partnership. If there is a negative adjustment such as an additional deduction, then the adjustment would happen in the tax year the audit report is finished, also known as the Adjustment Year. This would be reported on the partnership tax return and allocated to the partners.
Another downside to having the partnership pay the IU is that if there is a change to an income or deduction allocation among partners it could still result in the partnership paying the IU even though the overall net income did not change. The partnership will pay the IU on the income change and the partner with the income allocation downward will get the benefit at the partner level. This creates a large disparity in the tax payment allocation between the partners.
Fortunately, there is relief for partnerships who can elect out of the CPAR rules. By electing out partners can have any audit adjustments apply directly to them. This is generally advantageous because the partner’s tax bracket and mitigating tax items like a net operating loss, are taken into accounts. The additional income items from an audit adjustment also increases their outside basis in the partnership. The election out of CPAR is done on the 1065 tax form and only apples to partnerships with 100 or fewer eligible partners. Eligible partners include individuals, C corporations, S Corporations, Foreign Corporations, and Estates of deceased partners. It is important to note that trusts and single member LLCs are not included as eligible partners and thus are subject to the CPAR.
If a partnership has more than 100 partners or has ineligible partners there is further relief to avoid the impacts of a CPAR audit. Partners within the partnership can still amend their returns using the amended return protocols or elect to pull in their returns and have the IRS separately make the adjustments that are applicable to them. The partnership may also elect to push out the adjustment to the partners as well. Each of these options has their own advantages and disadvantages, so it is important to consider all options when deciding how to proceed with a CPAR audit.
The CPAR will have a drastic effect on how the IRS will proceed with the audits of the 2018 tax year partnerships. It is important that taxpayers are aware of the implications of these audits and how best to prepare for them. Amending partnership agreements and deciding on entity structures should be considered when tax planning with your trusted advisor. Please contact your RINA tax professional for further advice and consultation.