It is fairly common knowledge in CPA circles that the rate at which the IRS examines partnership returns has cratered. Because of this, it may have escaped notice that the IRS has methodically targeted structural weaknesses that prevented it from addressing noncompliance on Form 1065.

At the same time, professional liability claim data from the AICPA Professional Liability Insurance Program suggests that claims involving partnership returns often fall into one of two buckets: the aforementioned noncompliance or disputes that can be generically described as, “Where’s my cash?”

For example, in one partnership, a 20% partner whose capital account reflected over 80% of total capital wanted liquidation proceeds distributed per capital accounts. Why? That’s what the executed partnership agreement required. The other four 20% partners wanted liquidation proceeds distributed equally. Why? The executed agreement was drafted to reflect an equal economic interest deal. All five partners looked at the CPA and asked, “What happened?” The CPA did not have a good answer, and the claim ensued.

WHY NOW?

Disputes between partners happen all the time. This, plus the ambiguity surrounding IRS enforcement, makes now a uniquely opportune time to examine evolving risks involving partnership returns. There have been several discrete events involving partnership compliance that, when viewed collectively, should make any CPA who prepares Form 1065 pause and pay attention.

Changes to forms

Remember in 2004, when the Schedule K-1 format completely changed and added several codes? What about 2020, when partner capital was required to be presented on tax basis instead of book, GAAP, or other methods? Or 2021, when Schedules K-2 and K-3 (International) were introduced? These and other form changes over the years have steadily provided the IRS with more useful information. E-filing has made it easier for the IRS to mine that data and identify noncompliance, even in tiered partnerships.

Changes to changes

The passage of the Bipartisan Budget Act of 2015 (BBA) changed how changes to certain partnership returns are made. Involuntary changes (exams) to returns subject to the centralized partnership audit regime result in either partnership-level tax or adjustments pushed out to partners. Voluntary changes (amendments) to returns subject to the BBA must now be made on Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request (AAR). These reforms are significant and require familiarity with new forms and complex deadlines driven by the IRS’s overall compliance goals. Correcting errors under the BBA — once professional fees are factored in — may be more expensive than traditional audits or amended returns because the BBA by design pushes more work to taxpayers. That added expense may result in more clients pushing blame to the CPA.

Technical changes

Treasury continues to release a steady stream of partnership regulations, for example, the 2024 final regulations on recourse debt. When the IRS disagrees with the technical position and assesses penalties, the client may seek recompense from the CPA.

Tactical changes

The IRS knows it has problems examining partnerships and is changing tactics. Previously, the Service’s approach to auditing partnerships was splintered. The IRS recognized this and began working toward a higher level of consistency and effectiveness in how it evaluates compliance in this area. Specialist hiring and training increased. In addition to Global High Wealth and High-Income Taxpayer initiatives, the IRS launched a passthrough field operations unit, which combines the expertise of the Large Business and International (LB&I) and Small Business and Self-Employed (SB/SE) divisions. IRS Chief Counsel announced the creation of a new Associate Chief Counsel office to focus on partnerships and other passthrough entities. It may be only a matter of time before this newer, cohesive approach is felt across partnerships of all sizes.

Intra-client disputes

When partners argue, those arguments invariably touch upon cash. Partner disagreements that involve enterprise valuation, liquidity, buyout values, management, or finances in general, can become the basis of allegations against the CPA that prepared the return. Those allegations may become professional liability claims.

GET AHEAD OF THE RISK

The almost nonexistent examination rate may have lulled many CPAs into thinking that preparing Form 1065 is not a risky proposition. Moving forward, the structural changes at the IRS should force a rethink. CPAs desiring to get ahead of the risk curve may want to consider the following suggestions:

New client risks

With any new partnership client, request and obtain the most recent, executed partnership agreement, including amendments, and review historical allocations and key components such as outside basis (from inception?) and elections. If it appears the previous preparer did not conduct their own review and/or overly relied on “SALY,” this analysis could take on added importance. You get one chance to identify any mistakes and communicate them to the client. After that, they become your mistakes.

Technical competency risks

In line with recent IRS data on the number of Forms 1065 filed, CPAs may not view this as a “dabble” area. However, items such as sophisticated tax allocation provisions, noncash contributions, transfers of partnership interests, foreign partners or activity, or irregular business arrangements increase error potential and risk. CPAs should recognize when a client’s complexity has exceeded the CPA’s knowledge and, if necessary, direct the client to another professional. The increase in machine-readable detail presented on Form 1065 and Schedules K-1 and K-3 puts more emphasis on technical accuracy. Conversely, opportunities to bury ambiguous reporting positions and disclosures in footnotes have decreased.

BBA risks

CPAs should recognize that the BBA has completely changed the landscape for partnerships that either must comply with it or have not opted out. As more partnerships are being affected, the true scope of these changes is starting to become clearer. AARs have more moving parts and strategic considerations than a traditional Form 1065-X, some of which affect forms other than Form 1065. CPAs who are not yet familiar with this evolution or think the BBA will never impact their practice would be well advised to obtain a deeper understanding of the BBA’s implications.

Client relationship risks

As a practical matter, a CPA might communicate with only one partner — typically the majority partner — for information and engagement management. Often, the CPA also prepares that partner’s individual return. When the partners have financial and/or operational disagreements and need to go their separate ways, the CPA is routinely thrust into the middle of that dispute. At that point, intra-client (and sometimes family) dynamics combined with client communication habits may have already placed the CPA in an untenable position. In a claim, an outwardly cozy relationship with the majority partner combined with allegations that the CPA prioritized the partner at the expense of the client/partnership can be problematic. Where feasible, consider asking the primary contact:

• Is it possible to meet at least once (in-person or electronically) with all partners in attendance?
• To what extent should minority partners be involved in key planning discussions?
• Who is provided an opportunity to review the return or allocations prior to e-filing?

Asking these or other questions may be informative, especially if the majority partner goes to great lengths to keep other partners in the dark.

FINAL THOUGHTS

If your justification for a tax position on Form 1065 has ever been, “The IRS will never find it,” stop. The IRS very publicly resolved to change the perception and reality of partnership compliance. Client economic risks add more fuel to the fire, and for some partnerships, fixing previous mistakes is now more costly. Now is the time to pay attention.

CPAs who wish to learn more about the BBA should visit the IRS BBA centralized partnership audit regime page.

AICPA Tax Section members who wish to learn more about the BBA should visit the AICPA BBA Partnership Audit and Adjustment Rules FAQs.

Deborah K. Rood, CPA, MST, is a risk control consulting director at CNA. For more information about this article, contact specialtyriskcontrol@cna.com.

Continental Casualty Company, one of the CNA insurance companies, is the underwriter of the AICPA Professional Liability Insurance Program. Aon Insurance Services, the National Program Administrator for the AICPA Professional Liability Program, is available at 800-221-3023 or visit cpai.com.

This article provides information, rather than advice or opinion. It is accurate to the best of the author’s knowledge as of the article date. This article should not be viewed as a substitute for recommendations of a retained professional. Such consultation is recommended in applying this material in any particular factual situations.

Examples are for illustrative purposes only and not intended to establish any standards of care, serve as legal advice, or acknowledge any given factual situation is covered under any CNA insurance policy. The relevant insurance policy provides actual terms, coverages, amounts, conditions, and exclusions for an insured. All products and services may not be available in all states and may be subject to change without notice.