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New Partnership Tax Audit Rules Could Put You at Risk

If your firm is a TEFRA partnership -- and most partnerships are -- your tax game could be in for a change. Without much fanfare, new partnership audit rules were passed last December as appropriations riders.

And though they don't go into effect until 2018, lawyers should understand their implications today -- because if you're not prepared, you might be liable for past partners' unpaid taxes. So, here's what you need to know about TEFRA's new partnership audit rules.

Does TEFRA Apply to You?

Let's start at the start: identifying the TEFRA partnership. Almost all partnerships are covered by TEFRA, but many small firms can be excluded. According to the IRS, "generally, a partnership with 11 or more partners at any one time during the partnership's tax year is a TEFRA partnership." That means, if you're a law firm with 5 partners, you'll likely pass the small partnership exception test. These new audit rules won't apply to you -- but if you do get audited, the IRS will audit each partner individually, unless the firm has elected to follow TEFRA rules.

Of course, even if you're TEFRA-exempt, your clients might not be, so don't stop reading just yet.

What's Changing: Liability

With that out of the way, here's what's changing.

First, the IRS can now collect taxes associated with audit adjustments at the partnership level, rather than passing them through to individual partners. That means the change "effectively imposes entity-level tax on partnerships themselves," according to Kevin Johnson of Forbes's IRS Watch.

That's a significant change from current practice, in which the Service would collect tax directly from the partners, according to Scott Harty, a partner at Alston & Bird, who recently sat down to discuss TEFRA's "seismic shifts" with Inside Counsel. Previously, the Service would calculate the tax liability partner by partner, Now, "the default position is that the partnership is liable for any deficiency," according to Inside Counsel.

There are some ways attorneys can work around that partnership-wide liability, particularly if new partners don't want to get stuck with the tax liabilities of past partners. According to Harty:

It is possible for the partnership to shift the liability to those partners who were partners in the year being audited by making a separate election. If this election is made, the partnership is required to prepare and send out adjusted Schedules K-1 to the partners who must then take the adjustments into account on their tax return.

If there are less than 100 partners in your firm, you can elect out of the new audit rules.

Preparing Your Partnership Now

Opting out isn't the only action partnerships might want to take. Harty tells Inside Counsel that there's a host of changes and decisions partnerships should consider. First, partnerships should consider who to appoint as a representative, how the partnership will gather information from the partners, and what sort of notice and inspection rights partners will reserve. Such decisions should be included in the partnership agreement.

The new audit rules are expected to increase partnership audits and bring in more than $9 billion over the next 10 years, according to Inside Counsel. So make sure your prepared, should the IRS come after you.

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