New partnership audit rules replace amended returns with administrative adjustment requests
Like many taxpayers at tax time, sometimes partnerships realize that items reported on previously filed returns may need to be corrected in light of new information. This year, the process for making those changes will look significantly different from how it has in the past. New partnership audit rules went into effect for tax years beginning in 2018, and those rules include changes in how previous years’ returns are amended — changes so significant, in fact, that the process no longer even uses the term “amended return.”
If your partnership discovers information that necessitates a change in its 2018 return, it’ll need to file an “administrative adjustment request” with the IRS.
If your partnership discovers information that necessitates a change in its 2018 return, it’ll need to file an “administrative adjustment request” with the IRS. This new process is intended to align with the intent of the partnership audit rules. To do this, any liability for an underpayment of tax is assessed and collected at the partnership level, and it’s up to the entity to figure out how the change flows through to the partners. The recent tax extenders legislation and the ongoing IRS efforts to issue guidance regarding tax reform may cause considerable changes to 2018 partnership tax returns. Here’s how we think the process will look based on IRS guidance.
How it works for the partnership
When a partnership identifies an item that necessitates a change to a prior year return, the entity will file an administrative adjustment request with the IRS. Based on that filing, the partnership will:
- Determine whether there is an unfavorable adjustment creating an imputed underpayment or a favorable/negative adjustment.
- In the event of an imputed underpayment, determine whether the payment will stay at the entity level or if it’ll be pushed out to the partners. This determination may be spelled out in the partnership agreement. If the operating agreement is silent, the partnership representative will make the determination.
- In the event of a negative adjustment, the adjustment is always pushed out to the partners. When this happens, affected pass-through partners will be required to file tracking statements with the IRS to report how the adjustment passes through affected entities until it reaches the ultimate taxpayer.
How it works for the partner
The process looks a lot different from the partner’s standpoint as well. Depending on the partnership agreement, it’s possible that the partnership could resolve the issue without providing any additional information to the partners outside of the annual K-1 report. When an adjustment is pushed out to the partners:
- The partner takes the adjustment into account on the return in the year that the administrative adjustment request is filed (the “adjustment year”).
- Based on the information from the partnership, the partner recalculates its tax liability in the reviewed year and determines the amount of the correction to report for that year and any intervening year.
- The total correction amount is either added to the partner’s tax liability on the adjustment year return or, in the case of a negative adjustment amount, treated as a nonrefundable credit in the adjustment year.
Because it’s a nonrefundable credit, some partners may lose some or all of the benefit from a negative adjustment if they don’t have sufficient income in the adjustment year to use the full credit.
Key takeaways to remember
IRS guidance about the process makes a few things clearer to partners, including:
- The new rules are a big change from the previous amendment process. Affected partners will no longer be tracing partnership income changes back to the year of the original return and filing amended returns. It’s somewhat counterintuitive to report the tax impact of prior year income changes in the adjustment year, but the rules are very specific about how this works.
- A negative adjustment from a prior year won’t generate a refund in the adjustment year. Partners without sufficient tax in the adjustment year could lose some or all of a potentially significant tax benefit. Partnerships and partners should coordinate closely to ensure that the adjustment year of the partners will have sufficient tax or else it may consider filing the administrative adjustment request in a later year, as long as the latter is filed within the statute of limitations.
- The administrative adjustment request process provides a partnership with fewer options compared to what happens when adjustments are made during an IRS exam. Most notably, if an audit results in prior year changes, partners have an option to amend prior year returns, which isn’t available if the partnership files for the correction voluntarily.
If you own any partnership interests, it’s important to review your partnership agreement with your tax advisor to make sure that you understand how this process (and the new partnership audit rules in general) could affect your tax return. If you have any questions about how these changes could affect current or future tax returns, please contact your Plante Moran advisor.