The Internal Revenue Service has proposed guidance on the new partnership audit regime that promises to make it easier for firms, if not all their partners, but with some extra complications added by the new tax reform law.
The new guidance includes advice on how tax adjustments should be treated in tiered partnerships when the partners are in pass-through businesses. The audit rules go into effect at the start of the year, leaving businesses like hedge funds and private equity funds with not much time to get up to speed on how the rules (and this most recent guidance) affect their taxes, especially when more changes are coming from the Tax Cuts and Jobs Act that President Trump signed into law Friday.
The new partnership audit regime was included as part of the Bipartisan Budget Act of 2015. Section 1101 of the BBA repeals the current rules governing partnership audits and replaces them with a new centralized partnership audit regime that, in general, assesses and collects tax at the partnership level. These newly proposed regulations provide rules addressing how pass-through partners take into account adjustments under the alternative to payment of the imputed underpayment.
“Last week, the Treasury published new proposed regulations that will allow for a tiered pushout of the adjustment,” said Jeff Bilsky, technical practice leader for BDO USA’s National Tax Office Partnership Taxation group. “That basically gets us more or less back to the system that we have place in today with a couple of very important distinctions. There’s the potential for the ultimate individual taxpayer or corporate taxpayer up the chain of the tiered partnership structure to actually bear the cost of the tax. To me that’s a huge win, quite honestly, for taxpayers and tiered partnership structures. It’s fair and reasonable. There are some reporting requirements that go along with it. It certainly preserves the integrity of the tiered structure and the tax system that’s applied to partnerships. After those proposed regs came out last week, I think a lot of people are feeling much better about these rules in the context of who ultimately may have to pay the tax.”
The centralized partnership audit regime is supposed to make it easier for the IRS to audit large partnerships such as private equity firms and hedge funds. Instead of having to audit every single partner, it can audit the partnership as a whole. The old rules, from the Tax Equity and Fiscal Responsibility Act of 1982, or TEFRA, were replaced by the BBA centralized audit regime of 2015.
“What was required under the TEFRA rules is that the IRS completes the audit of the partnership, and they take the positive and the negative adjustments, so it increases or decreases the taxable income, and the government was actually responsible for taking those adjustments and running them through all the tiers of the partnerships,” said Bilsky. “Take a real simple example where you have an operating partnership that has a private equity fund and a couple of founder partners. The IRS audits that lower-tier partnership and determines whatever number of adjustments. For illustration, let’s say there’s a million dollar unfavorable adjustment, so there’s an increase in taxable income. The IRS is then responsible for taking that million dollars and figuring out how much is allocated to all of the partners, and how much goes to the PE fund. Once it gets to the PE fund it’s then responsible for figuring out how much of the PE fund share of the million gets allocated to all of its partners. It keeps working all the way up, however many tiers you have, until you ultimately get to a taxpayer. Only about 3 percent of partnerships get audited. Part of the problem is once you determine that million-dollar adjustment, your job at the IRS is just starting because you now have to go and figure out who is going to owe tax.”
That is going to change now with the new tax reform law as well as the new guidance on partnership audits, Bilsky noted. “This new tax law that goes into effect next year flips the payment obligation, and the intent is to say, ‘OK, IRS, you’ve done your audit. You came up with that million-dollar adjustment. Partnership, you either pay it, or your direct partner has to pay it.’ To a large extent, that’s not fair because the partnership should never bear a tax. That’s not what they do, and the immediate partners shouldn’t necessarily bear the tax because it may also be a pass-through entity. So what these new proposed regulations do is say, ‘OK, IRS, you completed the audit. You came up with this million-dollar adjustment. The partnership, you can either pay the tax and be done with it or you can do what’s referred to as a pushout election and you can push that million-dollar adjustment out to your partners and those partners can push that million-dollar adjustment out to its partners and so on.’ Eventually someone who receives this bill or this income allocation for the million dollars. If they’re an individual or a corporation, they can’t push it out and they just pay the tax. The gist of these new proposed regulations is to flip the burden away from the government for tracking and figuring out who owes the money to the partnership and say, ‘You guys know your partners. You figure it out. And you tell us who’s going to pay, and we’re going to collect from that person.’”
The new guidance doesn’t make it any easier or harder for the IRS to audit a large partnership.
“The actual audit of the partnership won’t necessarily get more or less complicated,” said Bilsky. “It’s really more about the collection of the tax that results from the audit. From that perspective, these rules make it significantly easier for the IRS to collect the tax on the IRS audit adjustments. What it also does is it contains a provision that allows the IRS to create an audit adjustment to the extent that not only have there been errors in determining income and expense at the partnership level, but also it can create these imputed underpayments as a result of incorrect allocations made by the partnerships.”
Partnerships aren’t necessarily getting off the hook with the new guidance.
“To me that’s a huge change and something that partnerships need to be thinking about, because in my experience partnership allocations are very complicated, and when we talk about private equity allocations it’s taken to a different level of complexity,” said Bilsky. “If the partnerships aren’t maintaining very detailed records, it can be relatively easy for the IRS to challenge the allocations, and that would create this imputed underpayment. So while the main point of these rules is to allow the government to collect these taxes easier, the way the law was written I think creates a huge opportunity for the IRS to come in and create these essential assessments simply by focusing on allocations of income as opposed to figuring out whether the income is correct or not.”
The new tax reform law signed into law Friday will add some more wrinkles, and some partnerships may decide to reorganize themselves as C corporations, or vice versa.
“There’s a huge decision that needs to be made, and that decision is should you continue to be a partnership,” said Bilsky. “As we know the corporate rates are dropping from 35 percent to 21 percent. That’s a huge drop. So should a partnership incorporate, and the flip side to that is, because the rates have dropped so far, some corporations are going to be thinking about liquidating and becoming a partnership. I think there’s going to be a lot of decisions being made about entity transformations, and reincorporation types of transactions. That’s likely to give rise to potential tax exposure areas, which would also encourage the IRS to look more carefully at the different entities, in this case partnerships, especially in light of these new rules that make it so much simpler for the government to collect tax. There’s somewhat of a roadmap to focus on different areas where there may be tax exposure.”
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