CPAs who serve as tax advisors to entrepreneurs and investors have a lot of worried clients these days, and with good reason.
The Internal Revenue Service is using billions of dollars in new funding from the Inflation Reduction Act for audits and artificial intelligence-powered scrutiny of tax returns. A sizable chunk of this enforcement effort is aimed at partnerships, one of the most common business structures across many sectors, including business, agriculture, energy and real estate.
The agency has announced it plans to use AI to identify potential compliance problems within its Large Partnership Compliance program in the following areas: partnership tax, general income tax, and accounting and international tax. Multiple industries will feel the pain.
This has many taxpayers involved in partnerships worried. One Chicago-based law firm, Baker McKenzie, even sued the IRS in March, demanding more public disclosure about its plans to crack down on partnerships. So, it will be interesting to see how this plays out.
In the meantime, it's crucial for those of us acting as their strategic tax advisors to think proactively. Understanding the implications of amending partnership tax returns — and how to use extensions to support your clients — is imperative for your practice.
Partnership tax law, already complex, became even trickier to navigate with the passing of the Bipartisan Budget Reconciliation Act in 2015. This act, replacing the Tax Equity and Fiscal Responsibility Act of 1982, created a centralized partnership audit group within the IRS to scrutinize partnership tax returns more heavily.
The act also changed the protocols for amending previously filed returns. There are limited exceptions, but most partnerships, including many small ones, will be subject to the BBA rules.
As a best practice, CPAs whose clients have partnership structures should automatically file extensions so that revisions can be made if new information is brought forth. Filing for an extension allows the CPA and the client time to prepare the best possible return and discover all relevant information.
For example, if new information comes in from a client in June and an extension has been filed, the CPA can easily adjust in the original return. Recognizing that many partnerships with multiple partners want to file their returns early, the tax preparer may think that no extension is needed. The benefit to doing so is that with an extension request, a "superseding return" can be filed, even if a return was filed on the due date. The superseding return automatically becomes the return of record — as long as an extension was filed.
If the return was filed with no extension request, the CPA must file an "Administrative Adjustment Request," which introduces multiple complexities and potential pitfalls to amending a partnership return.
The AAR imposes numerous processes in both calculating and attributing any additional tax liability or reduction to the filed return. Anyone who has done an AAR knows very well that it is far more complex than filing an amended, or superseding, return. Plus, any additional taxable income is reported in the year the AAR is filed, not in the original year it was earned. This can cause some unintended tax consequences for the partnership and its partners.
Most partnerships use the calendar year as their tax year, although other filing years are permitted. The partnership tax return is due by the 15th day of the third month following the end of the partnership's tax year. For most, that is March 15. Form 7004 can be filed to obtain an automatic six-month extension. The extension paperwork must be filed by the original deadline for the tax year.
Even for individual returns, there is no downside to filing for an extension, and there are many upsides. A better tax return, with maximum deductions, can be filed when it isn't rushed. Just remember that the extension is an extension of time to file, not an extension of time to pay. The tax liability should be estimated and paid by the original deadline.
Also, remember that the failure-to-pay penalty is only 0.5% per month, so some taxpayers will want to file the extension without paying their tax liability, effectively borrowing from the government for a few months. It's usually best to include the first-quarter estimate in the extension payment. That way, if additional tax was due for the prior year, there is no underpayment penalty for the prior year, just a potential estimated payment penalty for the current year.
Never forget to file the extension by the due date to avoid the 5%-per-month failure to file penalty. One quirk is that if the taxpayer does not file by the extended due date, the 5% per month penalty goes all the way back to the original due date.
Use extensions to proactively help your clients get the highest-quality tax strategy — and return — as possible.
