Schedule B-2 (Form 1065): Electing Out of the Partnership Audit

Schedule B-2 of Form 1065 is the attachment an eligible partnership files to elect out of the centralized partnership audit regime, so that any future IRS audit adjustments flow to the individual partners rather than being assessed against the partnership itself.¹ The election is open only to partnerships with 100 or fewer partners where every partner is an eligible type, and it must be renewed each year with a timely filed return.²

Why Small Partnerships Elect Out

The Bipartisan Budget Act of 2015 replaced the older partnership audit rules with a centralized regime that applies to all partnerships for tax years beginning after 2017. Under the default rules, if the IRS audits the partnership and finds an underpayment, the tax is assessed and collected at the partnership level.³ That entity-level liability is calculated as an “imputed underpayment” using the highest individual or corporate rate for the year under review, which has been 37% in recent years.⁴

Which Partnerships Qualify

Two conditions must be met for the tax year the election covers: 100 or fewer partners, and every partner must be an eligible type.²

The 100-Partner Count

The count is based on the number of Schedules K-1 the partnership is required to issue, with an important wrinkle for S corporation partners: each shareholder of an S corporation partner counts as a separate partner for the cap.⁶ A partnership with 80 direct partners plus one S corporation partner that has 25 shareholders reaches 105 and cannot elect out.

Eligible Partners

Every partner receiving a Schedule K-1 must fall into one of these five categories:

Individuals, including nonresident aliens filing as individuals.
C corporations (standard domestic C corporations).
S corporations, but each shareholder must be disclosed and counted.
Estates of deceased partners. An estate of a living individual does not qualify.
Foreign entities that would be classified as C corporations under U.S. entity classification rules if they were domestic.

Partners Who Block the Election

A single partner of the wrong type disqualifies the partnership for the entire year. Disqualifying partners include:

Another partnership, even a small one.
A trust. Trusts as direct partners are disqualifying, though a trust can be a shareholder of an S corporation partner without causing a problem.
A foreign entity that would be classified as a partnership, disregarded entity, or trust under U.S. rules.
A disregarded entity, such as a single-member LLC.
An estate of a living individual.
A nominee or agent holding an interest on behalf of another person.

Review the partner roster before starting the form. Ineligibility at any point in the tax year kills the election for that year.⁶

Completing the Form

Schedule B-2 has five parts. Most partnerships only need Parts I and III. Parts II and V come into play when there is an S corporation partner, and Parts IV and V are continuation sheets.

Part I: Eligible Partners

Part I is a three-column table listing every partner who received or should have received a Schedule K-1 for the year:

Column 1: the partner’s full legal name.
Column 2: the partner’s U.S. Taxpayer Identification Number. For foreign partners, the IRS may accept alternative identification as prescribed by the Secretary.
Column 3: a single-letter code identifying the partner type. I for Individual, C for Corporation, S for S corporation, E for Estate of a deceased partner, or F for a foreign entity that would be treated as a C corporation if domestic.

If none of those five letters fit a given partner, the partnership is not eligible to elect out.¹ Part I has room for 15 partners; use Part IV as a continuation sheet if you have more.

Part II: S Corporation Shareholders

Part II is required only when an S corporation is a partner. Enter the S corporation’s name and TIN at the top, then list the name, TIN, and type-of-person code for every shareholder of that S corporation during the S corporation’s tax year ending with or within the partnership’s tax year.¹ The shareholder codes differ from Part I: I for Individual, T for Trust, E for Estate of a deceased shareholder, and O for Other (which covers Section 401(a) pension plans, ESOPs, Section 501(c)(3) organizations, and eligible disregarded entities). If a single S corporation has more than 12 shareholders, continue on Part V. Complete a separate Part II for each S corporation partner.

Part III: The Count

Part III is the math that confirms eligibility:

Line 1: total partners listed in Parts I and IV.
Line 2: total S corporation shareholders listed in Parts II and V. Do not re-count the S corporations themselves; they are already on Line 1.
Line 3: add Lines 1 and 2. This total cannot exceed 100.

The Line 3 figure carries over to Form 1065, Schedule B, Question 25.¹

When and How to File

Schedule B-2 must be attached to a timely filed Form 1065, including extensions, for the tax year the election covers.² A late-filed return cannot carry a valid election, no matter how correctly the schedule is completed. If you think you will need more time, file the extension before the original due date.

The election does not roll forward. To stay outside the centralized regime, the partnership must complete and attach a new Schedule B-2 every year, reconfirming eligibility and updating partner information.¹

The partnership also has to notify each partner that the election has been made. The statute requires notice but doesn’t prescribe a form; sending written notice with each Schedule K-1 is a practical way to handle it.²

Mistakes That Void the Election

The IRS can determine that an election is invalid when Schedule B-2 is incomplete or wrong. A few problems come up repeatedly.

Bad TINs are the most common. The IRS validates every TIN on the form, and mismatches can void the election.¹ Verify each partner’s TIN against a W-9 or equivalent before filing. For S corporation partners, verify TINs for every shareholder too, not just the entity.

Forcing an ineligible partner through with the wrong code is another. If a trust or another partnership is a partner and someone enters “I” or “C” to make the election work, the IRS cross-references entity classifications and will reject the election. The correct answer in that case is that the partnership simply cannot elect out for that year.

Going over 100 is easy to miss when S corporations are in the mix. A partnership with 90 direct partners and two S corporation partners holding a combined 15 shareholders is at 105. Run the Part III calculation before assuming you qualify.

And a late-filed return, even by a day past the extended deadline, invalidates the election no matter how clean the schedule looks.

If You Don’t Elect Out

Without a valid election, the centralized regime governs any future audit. The partnership designates a partnership representative on Form 1065 who can act on the partnership’s behalf during an IRS examination, including agreeing to settlements and extending statutes, without partner approval.⁵

If an audit produces adjustments, the IRS calculates an imputed underpayment at the highest applicable rate and assesses it against the partnership in the current year, not the reviewed year.³ Current partners bear that cost even if they were not partners during the year under review. The representative can request modifications, for example by showing that some partners are tax-exempt or in lower brackets, but the process adds time and complexity.

The partnership can also make a “push-out” election under Section 6226, which shifts the adjustments back to the partners who were in the partnership during the reviewed year. Those partners then adjust their own returns and pay the additional tax with interest.⁷ It’s a workable backstop, but it comes with tight deadlines and after-the-fact administration that a clean Schedule B-2 election avoids from the start.

1
Internal Revenue Service. Instructions for Schedule B-2 (Form 1065)
2
Office of the Law Revision Counsel. 26 U.S. Code 6221 – Determination at Partnership Level
3
Internal Revenue Service. BBA Centralized Partnership Audit Regime
4
Internal Revenue Service. Instructions for Form 1065 – U.S. Return of Partnership Income
6
Internal Revenue Service. Elect Out of the Centralized Partnership Audit Regime
7
Internal Revenue Service. BBA Partnership Audit Process