Goering Center news

By Kelvin M. Lawrence, Esq.

The Bipartisan Budget Act of 2015 (BBA) changed how the Internal Revenue Service audits businesses taxed as partnerships (referred to in this article generically as partnerships) for tax years beginning on Jan. 1, 2018. Ohio conformed to these rules in the recent biennial budget, Am. Sub. H.B. 166 (H.B. 166), and other states are adopting similar tax laws. Businesses should amend their governing documents now to be prepared to respond to these audits, if and when they come.

The BBA audit rules allow the IRS to more easily identify an individual authorized to act on behalf of the audited entity by requiring every partnership to have a “partnership representative” with broad authority to bind the partnership and its partners, and by allowing the IRS to appoint one, if a partnership does not. The new rules also make multi-tier partnerships easier to audit by defaulting to assessment of tax at the partnership level rather than the partner level. Partnerships with certain types of partners and that issue fewer than 100 federal Schedules K-1 may opt out of the BBA rules, but this election must be properly requested every year.

Under the new rules, if an audit increases the tax due for a “reviewed year” under audit, the partnership generally must pay it as an additional tax for the “adjustment year” in which the audit concludes. This may burden partners in a later year for taxes attributable to an earlier year. An audited partnership may instead elect to push out the tax liability to its partners in the reviewed years, who may no longer be associated with the business. If the tax is pushed out, the BBA allows these partners to report the additional tax in the year the partnership sent a valid notice electing to push the tax out, without amending their reviewed-year federal tax returns.

Federal audit changes generally mean state income tax changes for a partnership and its partners. For large, multi-state businesses, a federal audit adjustment could mean amended state tax filings in dozens of states. As this article goes to press, 12 states, including Ohio, have adopted laws to address new federal partnership audit adjustments, and more are considering legislation. 

Ohio’s new partnership audit rules default to a procedure requiring an audited partnership to:

1. File a report of the federal adjustments with the state;
2. File statements notifying directly invested partners of their respective shares of the tax due; and
3. File an amended composite return, paying the tax due on behalf of its nonresident partners.

Partners directly invested in the audited partnership must file original or amended Ohio returns for the reviewed year, and pay any remaining tax due after the partnership’s payment. 

Alternatively, the partnership may notify Ohio and notify its partners of their share of the tax, and elect to file a return and pay tax on behalf of all of its partners at the highest Ohio income tax rate. By complying with this election, the partnership may satisfy the obligation of its directly invested partners to file amended Ohio tax returns. Under Ohio’s rules, the partners can file individual returns to claim refunds, if any, of tax the partnership overpaid by making this election. Under Ohio’s default option, partners that are themselves pass-through entities must also decide whether to pay the tax themselves or push it out to their own partners.

Every business taxed as a partnership should amend its governing documents with both federal and state tax rules in mind. Controls on appointment, removal, and control of the partnership representative are essential, as are methods for opting out and collecting amounts due from former partners. At the state level, many states have partnership audit rules that differ from one another, and from the federal rules. Partnerships must make hard choices about whether to push out a federal audit liability, and whether they can or should make the same choice in each state. These choices are particularly important if partners are considering moving, retiring, or making family members future owners of the business. Putting structures in place now to manage these complex audits can help avoid disagreements over how to handle future audit liabilities.

Kelvin M. Lawrence is a business and tax attorney with Dinsmore & Shohl LLP. Reach Kelvin at 614-628-6964 or at kelvin.lawrence@dinsmore.com.