Pros and Cons of the Centralized Partnership Audit Regime Election

The Bipartisan Budget Act of 2015 established the Centralized Partnership Audit Regime (CPAR) as the default method for the Internal Revenue Service (IRS) to audit partnerships. This framework streamlines the audit process by allowing the IRS to assess and collect tax adjustments at the partnership level, rather than from each partner individually. Under CPAR, any tax deficiency found during an audit is generally paid by the partnership in the year the audit concludes.

A key feature of these rules is the provision for certain partnerships to make an annual election to opt out of this centralized system. By making this election, a partnership chooses to have any audit adjustments handled under older, partner-level examination procedures. This decision carries significant implications for how tax liabilities are determined, who bears the financial burden, and the administrative responsibilities of the partnership and its partners.

Eligibility Requirements for the Election

A partnership’s ability to elect out of CPAR hinges on meeting two requirements for the given tax year. The first is the 100-or-fewer partners rule. To satisfy this, the partnership must be required to furnish 100 or fewer Schedule K-1s to its partners, a count that includes every Schedule K-1 the partnership issues, not just a tally of the partners themselves.

The second requirement relates to the types of partners within the partnership. To be eligible to elect out, every partner must be an “eligible partner.” The IRS defines eligible partners as individuals, C corporations, S corporations, and estates of deceased partners. A foreign entity may also be an eligible partner if it would be treated as a C corporation if it were a domestic entity. The presence of even one ineligible partner disqualifies the entire partnership from making the election for that year.

Ineligible partners include other partnerships, trusts, and disregarded entities like single-member LLCs. For example, if a family partnership includes a trust as a partner for estate planning purposes, it immediately becomes ineligible to elect out of CPAR. Similarly, a tiered partnership structure, where one partnership is a partner in another, automatically subjects the lower-tier partnership to the centralized audit rules.

When a partnership has an S corporation as a partner, the partnership must include the K-1s the S corporation issues to its own shareholders in the total count. For instance, a partnership with 10 individual partners and one S corporation partner that has 91 shareholders would have a total count of 102 K-1s, making it ineligible to elect out.

How to Make the Election

The election to opt out of CPAR must be completed annually on a timely filed partnership tax return. A partnership that qualifies and elects out in one year must repeat the process the following year if it wishes to remain outside the CPAR system. Failure to make the election on a timely filed return, including extensions, means the partnership automatically falls under the default CPAR rules for that year.

The election is made on Form 1065, U.S. Return of Partnership Income. The partnership must check the designated box on Schedule B of the form, which asks if the partnership is electing out of the centralized partnership audit regime under section 6221.

Beyond checking the box, the election requires specific disclosures. The partnership must complete and attach Schedule B-2 (Form 1065), Election Out of the Centralized Partnership Audit Regime. On this schedule, the partnership is required to provide detailed information for every partner, including their name, taxpayer identification number (TIN), and their specific type as an eligible partner. For any S corporation partners, the partnership must also list the name and TIN of each of its shareholders.

Finally, the partnership must inform each of its partners that the election has been made for the year. This ensures that all partners are aware that any potential audit adjustments for that tax year will flow through to them directly, rather than being handled at the partnership level.

Primary Advantages of Electing Out

An advantage of electing out is the shift of tax liability from the partnership to the individual partners. When a partnership remains under CPAR, any tax deficiency is typically assessed against the partnership itself in the current year, regardless of which partners were present in the year under review.

Electing out avoids this outcome. Instead, any adjustments are passed through and assessed to the individuals who were partners during the audited year. This ensures the tax burden falls on those who received the original economic benefit.

Another benefit is avoiding the “imputed underpayment.” Under the default CPAR rules, a tax deficiency is calculated as a single partnership-level liability. This amount is generally calculated by multiplying the total adjusted income by the highest individual or corporate tax rate in effect for the reviewed year. By electing out, the partnership sidesteps this calculation, as the tax is instead determined at the partner level based on each partner’s specific tax situation.

When adjustments flow through to the partners, each partner can use their own unique tax circumstances to mitigate the impact. A partner may have net operating losses, capital loss carryforwards, or tax credits that can be used to offset the additional income from an audit adjustment. These individual tax attributes are disregarded when the tax is paid at the partnership level via an imputed underpayment.

Electing out also diminishes the authority granted to the Partnership Representative (PR) under CPAR. The CPAR framework gives the PR the sole authority to act on behalf of the partnership and all its partners in an IRS audit. By electing out, the PR’s authority for that year is nullified, and each partner regains control over managing their portion of an audit, including the right to negotiate their own settlement with the IRS.

Key Disadvantages of Electing Out

Choosing to elect out of CPAR means the partnership and its partners revert to the audit procedures that existed before the centralized regime, which can be complex and fragmented. Instead of a single, unified audit at the partnership level, the IRS must open separate proceedings for each partner to make adjustments and assess tax. This process can be more time-consuming and lead to a prolonged audit experience.

While electing out shields the partnership entity from a direct tax assessment, it transfers the administrative load to the individual partners. Each partner will receive separate notices from the IRS regarding their share of the audit adjustment. This requires each partner to independently engage with the IRS, potentially amend their own prior-year tax returns, and manage the process of paying any resulting tax and penalties.

The requirement to make the election annually introduces a degree of risk. An administrative oversight, such as forgetting to check the box on Form 1065 or filing the return late, will cause the partnership to default into the CPAR rules for that year. This can disrupt the partnership’s tax planning and requires vigilance from the partnership’s management and tax preparers.

A partnership’s eligibility to elect out is not guaranteed from one year to the next. A change in the partnership’s structure can render it ineligible. For example, if a partnership that previously consisted only of individuals admits a trust or another partnership as a new partner, it will lose its eligibility to elect out. Similarly, if the number of partners grows beyond the 100-K-1 limit, the option to elect out is lost.