How to Make the Partnership Audit Regime Election

The Bipartisan Budget Act of 2015 (BBA) changed how the Internal Revenue Service (IRS) audits partnerships, creating a centralized audit regime as the default system for tax years after 2017. Under this framework, the IRS conducts audits and collects tax at the partnership level rather than examining each partner individually. This streamlined process was designed to make auditing large partnership structures more efficient for the government.

While this is the standard procedure, the law allows certain qualifying partnerships to opt out of this system. This “election out” lets a partnership have its items audited under the former rules, where the IRS deals directly with the individual partners for any adjustments.

Eligibility Requirements to Elect Out

To opt out of the centralized audit regime, a partnership must satisfy two conditions regarding its size and partner composition. The first requirement is that the partnership must issue 100 or fewer Schedules K-1 to its partners for the tax year. When an S corporation is a partner, the number of Schedules K-1 it issues to its own shareholders must be added to the partnership’s total count.

For example, a partnership with 60 direct partners that also has an S corporation partner with 45 shareholders would count 105 statements (60 + 45). This total exceeds the 100-statement limit, making the partnership ineligible to elect out.

The second condition is that all partners must be “eligible partners.” These include individuals, C corporations, estates of deceased partners, and S corporations. Certain foreign entities that would be treated as C corporations if they were domestic also qualify. The presence of even one ineligible partner, such as another partnership, a trust, or a disregarded entity like a single-member LLC, disqualifies the partnership from making the election.

Required Information and Disclosures

Making a valid election requires the partnership to gather and disclose specific information for every partner to the IRS. The partnership must provide the full legal name, a correct taxpayer identification number (TIN), and the federal tax classification for each partner. For individual partners, the TIN is their Social Security Number (SSN), while for corporate partners, it is their Employer Identification Number (EIN).

This partner information must be reported on Schedule B-2, “Election Out of the Centralized Partnership Audit Regime,” which is an attachment to the partnership’s Form 1065 tax return. If a partner is an S corporation, the partnership must also list the name and TIN for each of that S corporation’s shareholders on Schedule B-2. Missing or incorrect information on this schedule can lead the IRS to reject the election.

How to Make the Annual Election

The election to opt out is an annual requirement tied to the partnership’s tax filing and cannot be made for multiple years at once. To execute the election, the partnership must check the designated box on Form 1065, Schedule B, which asks if the partnership is electing out of the centralized audit regime under section 6221.

The election is only considered valid if it is made on a timely filed partnership return, including any approved extensions. Filing the return after the deadline without a valid extension will render the election invalid, subjecting the partnership to the BBA regime for that year.

Consequences of the Election Decision

If a partnership successfully elects out, the IRS cannot use the centralized BBA procedures. Instead, any adjustments to partnership items are audited and assessed at the individual partner level. This means the IRS must open separate proceedings with each partner, which gives each partner direct control over their own audit defense and settlement negotiations.

If a partnership does not or cannot elect out, it remains within the default BBA regime. A primary feature of this system is the “imputed underpayment,” where any tax deficiency is assessed against the partnership itself. This amount is calculated using the highest individual or corporate income tax rate for the year under review.

A partnership under the BBA regime must also designate a Partnership Representative (PR). This individual or entity has the sole authority to act on behalf of the partnership and all its partners in any dealings with the IRS. The partnership pays the imputed underpayment in the year the audit is finalized, not the year being audited, which can create financial complications for the current partners.