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

Schedule B-2 of Form 1065 is the attachment a partnership files to elect out of the centralized partnership audit regime, so that any future IRS adjustments are handled at the partner level instead of being assessed against the partnership itself.¹ Only partnerships with 100 or fewer partners qualify, and every partner must fall into one of a short list of eligible categories.² It is not an income or deduction schedule; it is a one-year election that has to be made again with each year’s return.

Why Partnerships Elect Out

Under the centralized regime, if the IRS audits a partnership and finds an underpayment, it computes an “imputed underpayment” at the highest individual or corporate rate in effect for the year under review, which has been 37% in recent years.³ That tax is then assessed against the partnership in the current year, meaning whoever is a partner when the bill lands pays it, regardless of who was a partner during the year audited.⁴

Electing out shuts off that mechanism. Adjustments instead flow through to each partner’s personal return for the year under review, taxed at that partner’s actual rate. A small partnership whose partners are all individuals in bracket ranges well below 37%, and who have been the same partners for years, generally has little to gain from staying in the regime and a measurable amount to lose.

Staying in the regime also means designating a partnership representative with sole authority to bind the partnership and every partner to settlements, extensions, and other decisions, without partner consent.⁵ For partnerships where everyone is active in the business, that concentration of authority is often not what the partners want.

Who Can Elect Out

Two conditions have to 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. If any partner is an S corporation, each shareholder of that S corporation also counts toward the 100.⁶ A partnership with 80 direct partners plus an S corporation partner that has 25 shareholders is at 105, which is over the limit.

Eligible Partners

Every partner receiving a K-1 must be one of the following:

An individual, including a nonresident alien filing as an individual
A C corporation
An S corporation (with every shareholder also disclosed and counted)
An estate of a deceased partner
A foreign entity that would be classified as a C corporation if it were a domestic entity

Those five are the only eligible categories.¹

Partners That Block the Election

One wrong partner disqualifies the entire partnership. The election is unavailable if any K-1 recipient is:

Another partnership, even a small one
A trust (though a trust can be a shareholder of an S corporation partner without causing a problem)
A foreign entity that would be classified as something other than a C corporation under domestic rules
A disregarded entity, such as a single-member LLC
An estate of a living person
A nominee or agent holding an interest for someone else

Review the partner roster before starting Schedule B-2. If any partner falls into a disqualifying category at any point during the tax year, the election cannot be made for that year.⁶

Filling Out the Form

Schedule B-2 has five parts. Most partnerships only use Parts I and III.

Part I: Eligible Partners

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

Column 1: the partner’s full legal name
Column 2: the partner’s U.S. Taxpayer Identification Number (the IRS may accept alternative identification for foreign partners as prescribed by the Secretary)
Column 3: a single-letter code for partner type: I for individual, C for C corporation, S for S corporation, E for estate of a deceased partner, F for a qualifying foreign entity

If the code you need to enter isn’t one of those five letters, the partnership isn’t eligible.¹ Part I has room for 15 partners; use Part IV as a continuation sheet beyond that.

Part II: S Corporation Shareholders

Fill in Part II only when the partnership has at least one S corporation partner. Enter the S corporation’s name and TIN at the top, then list the name, TIN, and type code for every shareholder of that S corporation during its tax year ending with or within the partnership’s tax year.¹

Shareholder codes differ from the Part I set:

I for individual
T for trust
E for estate of a deceased shareholder
O for other, which covers Section 401(a) pension plans, ESOPs, Section 501(c)(3) organizations, and eligible disregarded entities

If an S corporation has more than 12 shareholders, continue onto Part V. Complete a separate Part II for each S corporation partner.

Part III: The Qualifying Math

Part III is where eligibility is confirmed on paper.

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: Lines 1 and 2 added together; this number cannot exceed 100

The Line 3 total is then reported on Form 1065, Schedule B, Question 25.¹

When and How to File

Schedule B-2 has to be attached to a timely filed Form 1065, including extensions, for the year the election covers.² A late return cannot carry a valid election, no matter how carefully Schedule B-2 is completed. If more time is needed, file an extension before the original due date.

The election does not roll forward. A new Schedule B-2 has to be prepared and filed every year, with fresh confirmation of partner eligibility and current information.¹

The partnership also has to notify each partner that the election has been made. The statute requires the notice but does not prescribe a format, so written notice sent with the K-1 works.²

REMICs filing Form 1066 can use Schedule B-2 under the same instructions.¹

Mistakes That Invalidate the Election

The IRS can treat the election as invalid if Schedule B-2 is incomplete or wrong. A few preventable errors cause most of the problems.

TIN errors 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, and do the same for every shareholder of every S corporation partner.

Using an ineligible partner code is the next trap. Entering “I” or “C” for what is really a trust or another partnership does not work; the IRS cross-references entity classifications and will reject the election. If a partner isn’t on the eligible list, the partnership simply cannot elect out that year.

Miscounting partners is easy when S corporations are involved. A partnership with 90 direct partners plus two S corporation partners carrying 15 shareholders between them is at 105. Run the Part III calculation before assuming the partnership qualifies.

Filing late, even by a day past the extended deadline, breaks the election regardless of how clean the form is.

If You Don’t Elect Out

Without the election, the centralized regime applies. The partnership designates a partnership representative on Form 1065, and that person can agree to settlements and extend statutes of limitations without partner approval.⁵ If an audit produces adjustments, the imputed underpayment is calculated at the highest applicable rate and assessed against the partnership in the current year.⁴ The representative can request modifications (for example, to reflect tax-exempt or lower-bracket partners) or make a “push-out” election under Section 6226 to send adjustments to the partners who were actually in the partnership during the reviewed year, who then adjust their own returns and pay with interest. The push-out carries its own strict deadlines, and missing them means the partnership pays the imputed underpayment.⁷ That is the machinery a valid Schedule B-2 keeps the partnership out of for the year it covers.

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. How to Figure an Imputed Underpayment
4
Internal Revenue Service. BBA Centralized Partnership Audit Regime
5
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