Businesses that are structured as partnerships for federal income tax purposes have seen their audit activity increase – here's what you need to know.
- The general rule under the new partnership audit rule is for partnerships to be taxed at the entity level.
- Companies should factor in new partnership audit rules when determining how they will structure their operation.
- If a partnership decides to follow the general rule, any current year partners may be on the hook for tax liability that resulted from a previous year.
Speak to one of our experts to learn more about how to protect your cannabis investment from previous tax liabilities.
Has tax season got you worried about getting audited?
Cannabis companies are more likely to get audited by the IRS than your average small business. But with a little preparation and some background knowledge about the rules and regulations, you can keep your company compliant.
Cannabis and tax regulations are complex, and the rules governing partnership audits are no different. The Bipartisan Budget Act of 2015 (BBA) set forth the procedures and rules relating to partnership audits. These rules set forth standards for tax years that begin after December 31, 2017. That means for your 2018 taxes, you need to know what’s different since the original rules were set forth in 1982.
Here’s a quick primer on the partnership audit rules your cannabis company needs to know about.
Partnership Audit Rules: Some Background
The Bipartisan Budget Act of 2015 (BBA) set forth the procedures and rules relating to partnership audits; these rules are changed for tax years that begin after December 31, 2017.
Prior to the BBA, partnership audits were conducted in accordance with the rules and procedures that were established with the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA).
Under TEFRA, any audit adjustments determined at the partnership-level had to be allocated out to the partners. The IRS then had to assess any applicable tax and penalties at the partner level. Given the volume of partners and the complexities associated with tiered partnership structures, partnership audits were administratively burdensome for the IRS.
To combat this, the BBA created rules and procedures that allow the IRS to audit and assess tax at the entity level. For most partnerships, this is an unwelcome change. There is generally no desire to pay tax at the entity level. However, for partnerships operating in the cannabis industry, the changes made to the partnership audit rules may be welcome.
This has big implications for how you structure your cannabis business. For businesses that have historically operated as C corporations to mitigate the administrative hassle of tax audits, they now have the opportunity to be structured as partnerships.
How the new partnership audit rules impact cannabis operators
For businesses that are structured as partnerships for federal income tax purposes, many of the owners of these businesses have seen their audit activity increase. Unsurprisingly, audits of individual taxpayers’ returns create stress and costly administrative burden.
The changes enacted as a result of the BBA can reduce the time and resources required of cannabis operators facing an audit. Since tax liabilities can now be assessed at the partnership level, it seems there should not be a need for the IRS to open audits at the partner-level. As an individual, this saves you time, money, and resources.
The general rule under the new partnership audit regime is for partnerships to be taxed at the entity level. However, there is an election that can be made by partnerships to “push-out” any imputed underpayment amounts to their partners.
Should partnerships follow the general rule and pay any potential imputed underpayment at the partnership level, the tax liability will be assessed at the highest applicable tax rate regardless of the attributes of its particular partners. It will be the partnership’s responsibility to prove the characteristics of its partners in order to minimize any potential tax liability.
To illustrate, assume that a 50/50 partnership has an unadjusted imputed underpayment of $100. The $100 is based on both partners being subject to the highest (i.e., 37%) tax rate. However, if one of the partners were a tax-exempt entity, the partnership may provide details regarding their partner profile in order to decrease the amount of the imputed underpayment to $50.
Another important consideration to take into account is if a partnership decides to follow the general rule, any current year partners may be on the hook for tax liability that resulted from a previous year (i.e., the reviewed year). For example, assume A acquired a partnership interest in 2018 and then disposed of it to C in 2020. If the partnership were audited and assessed an imputed underpayment at the partnership level for tax year 2018 in 2021 (when C is a partner), then C would ultimately be bearing the cost of a tax liability that resulted from when A was a partner. This simple illustration shows why it is important for new partners entering a partnership to understand how the partnership intends to treat any potential tax liabilities that arise from audits.
Key takeaways for cannabis companies
Companies should give careful consideration to the new partnership audit rules when determining how they will structure their operations. Additionally, new investors and owners should understand how any historical tax liabilities will be handled when they are acquiring an interest within the partnership. New partners should consider these liabilities when negotiating the acquisition of partnership equity as any unforeseen tax liabilities may be detrimental to their return on investment from the partnership.
If you have any additional questions about partnership audits or setting up your cannabis entity, get in touch with our tax advisors by clicking the button below.