How the partnership audit procedures may affect your partnership

There are specific  partnership audit procedures that apply for partnership tax years beginning after 2017. As under the pre-2018 partnership audit rules, the IRS audits partnerships at the partnership level. However, under the post-2017 partnership audit procedures, the adjustments are ordinarily imposed at the partnership level and partners do not have the opportunity to opt out of the partnership procedures. Partnerships must designate a partnership representative with a substantial presence in the U.S. The partnership representative will have the authority to bind the partnership; if no partnership representative is appointed, the IRS will designate one. In general, it makes sense for partnership to designate their partnership representatives when they are formed.

A partnership may elect out of the partnership audit procedures if (i) the partnership is required to furnish 100 or fewer statements to partners or nominees for the year, treating each statement that must be furnished to an S corporation shareholder as a separate statement and (ii) each statement the partnership is required to furnish for the year is furnished to an individual, a C corporation, a foreign entity that would be treated as a C corporation if it were a domestic entity, an S corporation, or an estate of a deceased partner. Thus, if statements have to be furnished to partnerships, trusts, foreign entities not described above, disregarded entities, estates of individuals other than a deceased partner and any person that holds an interest on behalf of another person, the partnership cannot make the election. A partnership must make the election on its timely filed return for the tax year to which the election applies and must notify its partners of the election within 30 days of the day it makes the election.

Under the partnership audit procedures, the IRS may make adjustments to (i) any item or amount relating to the partnership that is relevant in determining the income tax liability of any person and (ii) any partner’s distributive share of any such item or amount. In general, an imputed underpayment will be determined (a) by netting all partnership adjustments for the reviewed year and (b) applying the highest individual or corporate tax rate to the adjustments. Special rules apply so that items of different characters aren’t netted against each other.

The partnership audit procedures provide partnerships with the opportunity to suggest modifications to imputed underpayments. Thus, a partnership that receives a notice of proposed partnership adjustment (NOPPA) may request a modification of the imputed underpayment based on various grounds, including the character of its partners (e.g., a tax-exempt organizations). The IRS may file a notice of a final partnership adjustment (FPA) no earlier than 270 days after the NOPPA is filed. Thus, a partnership has at least 270 days to request a modification of an imputed underpayment.

Although imputed underpayments, and interest and penalties, are ordinarily imposed at the partnership level, the partnership may elect to have imputed underpayments taken into account at the partner level. If the election is made, the partnership must provide statements to each of its partners notifying the partner of its portion of the imputed underpayment and the partners would have to pay their portions of the imputed underpayment and the interest and penalties.

An FPA is the equivalent of a notice of a deficiency and gives the partnership the right to file a readjustment petition in Tax Court within 90 days of the FPA. The partnership may also file a readjustment petition in a district court or the Court of Federal Claims, but it must pay the tax before it files a petition in those courts. A partnership is also allowed to file an administrative adjustment request (AAR) to adjust partnership-related items unless it has received a notice of an administrative proceeding from the IRS.

Common Errors That Can Waive the Practitioner/Taxpayer Confidentiality Privilege

1. Including privileged information in the tax return or other filings with the IRS or state.
2. Disclosing privileged information in non-governmental filings, such as financial statements.
3. Mixing privileged communications with non-privileged communications or discussions.
4. Including third parties not critical to the subject of the privileged communication in the discussions.
5. Permitting access to privileged files by staff not engaged in the privileged engagement.
6. Permitting an engagement involving privileged communications to be managed by a staff member who is not an attorney, CPA, or enrolled agent or actuary.
7. Not segregating written privileged communications in separate files.
8. Not segregating electronic privileged communications from other files.
9. Not obtaining the written consent of the client before releasing any privileged information.
10. Failing to claim the privilege when the IRS requests privileged documents or other communications.
11. Allowing the privileged information to be used for non-tax matters.
12. Disclosing the privileged information to third parties, including governmental bodies and private businesses (such as banks).
13. Failing to educate clients about the fundamentals of the privilege, thus increasing the chances that the client can inadvertently waive the privilege.
14. Not marking every privileged communication as privileged.
15. Not billing separately for privileged engagements.

 Surviving an IRS Audit

• • Objective. you must convince the IRS that you reported all of your income and were entitled to any credits, deductions, and exemptions that are questioned.

• • Request Audit Delay when possible. Postponing the audit usually works to your advantage. Request more time whenever you need it to get your records in order, or for any other reason.

• • Do not allow IRS to conduct the audit at your home or place of business. Keep the IRS from holding the audit at your business or home. Instead, go to the IRS or have YAHNIAN LAW CORPORATION handle it. Field audits (at your place) are used mainly when there is business income; consult YAHNIAN LAW CORPORATION before hosting a field audit. If you retain us, it is most likely that you will not even have to appear at the audit.

• • Record Preparation. If you are missing receipts or other documents, you are allowed to reconstruct records.

• • Manage your expectations. Don’t expect to come out of the audit without owing something. . Don’t try to compromise on the amount of taxes to be paid; instead, negotiate the tax issues with the auditor.

• • Don’t Elaborate on auditor questions. Give the auditor no more information than he is entitled to. Do not speak any more during the audit than is absolutely necessary. Don’t give copies of other years’ tax returns to the auditor. In fact, don’t bring to an audit any documents that do not pertain to the year under audit or were not specifically requested by the audit notice.

• • Research. Research tax legal issues by using free IRS publications and commercial tax guides. If you are still unclear about the tax law or how to present your documents to an auditor, consult YAHNIAN LAW CORPORATION before the audit. Better yet, have YAHNIAN LAW CORPORATION handle the audit for you.
    Know your rights. Review  IRS Publication 1, explaining the Taxpayers’ Bill of Rights, prior to your audit. If the audit is not going well, demand a recess to consult YAHNIAN LAW CORPORATION. Ask to speak to the auditor’s manager if you think the auditor is treating you unfairly. If the subject of tax fraud comes up during an audit, don’t try to handle it yourself. At that point, you most definitely need legal counsel. Don’t even talk to your accountant. There is no accountant client privilege for criminal tax matters.

• • Time is on your side. The IRS must complete an audit within three years of the time the tax return is filed, unless the IRS finds tax fraud or a significant underreporting of income.

• • Appeal the results. When you get the examination report, call the auditor if you don’t understand or agree with it. Meet with him or his  manager to see if you can reach a compromise. If you can’t live with an audit result, you may appeal within the IRS or go on to tax court.

When the IRS examines returns of attorneys, there are specific issues they look for. Thus, if you should be chosen for an audit, it’s important that we appropriately document your compliance with these issues. This will help reduce additional costs to you in the future should an audit arise.

1. IRS prior 3 year analysis

If you are chosen for an audit, the IRS will perform a comparative analysis of at least three years during the pre-audit planning phase. During this phase, they will determine if there are any unusual changes in income, expenses and taxes paid for those prior years. Thus, it is important that I review your last three year tax returns so we can document any unusual changes such as I just described.

2. Attorney Specialties

The IRS will also build its audit around an attorney’s specialty. For example, criminal and immigration attorneys may receive more cash for services than other types of lawyers, as their clients may not use U.S. banks. Thus, the IRS will look at Currency Transaction Reports posted to the Information Returns Program (IRP) transcripts to see if an attorney has received large cash payments. They will then track those payments back to the attorney’s tax return. IRP transcripts provide information about payments an attorney receives that are reported to the IRS. For example, these transcripts provide information about reported Forms 1099, Currency Banking Retrieval System report summaries, social security payments, rental income, property sales, and interest and dividend payments.

3. Costs Advanced on Client Behalf

If you pay litigation expenses on behalf of your clients, the IRS will verify whether or not these payments have been deducted. Courts have determined that costs paid on behalf of a client are to be treated as in the nature of loans for tax purposes. They are not deductible as a current cost of conducting business. The costs are those of the client and not the attorney since there is an expectation of reimbursement. A bad debt deduction may be taken in the year that any costs are determined to be uncollectible.

4. Bookkeeping System Review and Analysis

The IRS will also want a thorough understanding of your bookkeeping system and internal controls, especially as they relate to any trust accounts that you control. Your business should have a written accounting manual which describes these procedures. If you have one, I will want to review it. If you do not have one, I can help you prepare one.

5. Earned Income Contained in Trust Accounts

If you control trust accounts into which settlement and award proceeds have been deposited, the IRS will check to see if you have attempted to defer earned income by allowing fees to remain in the trust account until the following year. Generally, once a settlement is received, the attorney’s fee is both determinable and available and therefore includible in income. However, if there are some extenuating circumstances which preclude income recognition, we need to appropriately document those circumstances.

6. Non cash Transactions

If you receive noncash compensation, for example in a bartering transaction, the IRS will want to see documentation of how such compensation has been valued and recorded in income.

7. Entertainment and Meals Deductions

The IRS pays particular attention to deductions for entertainment and meals. Generally, to be deductible, entertainment must meet either a “directly related” or “associated with” test. The “directly related” test generally cannot be met where there was little or no possibility of engaging in the active conduct of trade or business. This would apply, for example, in situations where you were not present. However, even if you were present, the rules state that there is little or no possibility of engaging in business where distractions are substantial, such as when the meetings or discussions occur at nightclubs, theatres, sporting events, cocktail parties, or social gatherings. In one instance, an attorney gave a party at a country club that was attended by some clients, persons who referred clients, and other business associates. The attorney could not deduct the expense incurred for the party because no business was discussed. The business purpose and business discussions must be properly substantiated. Any expenses rejected by the IRS because of improper, ill-kept, or non-existent records can result in substantial penalties.

8. Personal Service Corporations (PSCs)

When an attorney works for a personal service corporation, the IRS will scrutinize whether or not there are any constructive dividends or additional wages as a result of the corporation paying the attorney’s travel, meal, entertainment, and other personal expenses. If you have received a lot of reimbursements of such expenses, we need to ensure that the business purpose is appropriately documented.

9. Employee Status of Independent Contractors

Finally, if you treat receptionists, secretaries, paralegals, or law clerks as independent contractors, there may be some potential employment tax exposure. If this is the situation in your case, we need to document the facts that support such treatment.