On November 2, President Obama signed the Bipartisan Budget Act of 2015 into law. Along with purely budget-oriented matters, a revenue-raiser in the form of radically new partnership audit rules suddenly slipped into the mix and became part of final enacted legislation. Not even a month earlier, these partnership provisions were still considered in their formative stage … until someone saw that they could quickly provide almost a $10 billion offset that helped facilitate the budget deal.
As a nod to the hurried insertion of these new partnership rules into the Tax Code, Congress provided for a delayed effective date. Further, some members expressed the expectation that Internal Revenue Service guidance and possible technical corrections would help smooth out remaining concerns before mandatory implementation is triggered for partnership tax years starting after Dec. 31, 2017. Nevertheless, partners and partnerships would do well to consider strategies under these new audit procedures earlier than this 2018 effective date.
The new law moves as close as possible to imposing an entity-level tax on a pass-through entity. This is accomplished by essentially providing for partnership audits, from which tax adjustments will be assessed at the partnership level. Although the stated purpose of the new law’s partnership audit provisions is to make it easier for the IRS to audit large partnerships, including multi-tiered structures and hedge/private equity funds, even smaller partnerships will feel
the impact.
BACKGROUND
Before introduction of the revised partnership rules within the Tax Equity and Fiscal Responsibility Act of 1982, partnership returns generally were audited as adjuncts to the audits of partners’ returns. Since the individual partners’ returns were separately audited, any given partnership item could be subject to separate administrative procedures and possibly inconsistent treatment.
TEFRA introduced procedures where the partnership itself would be audited, and adjustments made at the partnership level would flow through to the returns of the individual partners. These rules were further supplemented, notably in the form of an Electing Large Partnership procedure by the Taxpayer Relief Act of 1997. Nevertheless, coordinating audits and pursuing individual partners following a partnership adjustment proved to be a growing problem, particularly as partnerships expanded to become the entity of choice for many businesses and investors.
The Bipartisan Budget Act changes the three existing regimes used for auditing partnerships. The rules prior to the Bipartisan Budget Agreement Act (which remain effective until 2018) provide:
- Partnerships with more than 10 partners are audited under unified TEFRA procedures that are then binding on the partners;
- Partnerships with 100 or more partners that elect to be treated as Electing Large Partnerships are subject to a unified audit under which any adjustments are generally reflected on the partners’ current-year return, rather than on an amended prior-year return; and,
- Partnerships with 10 or fewer partners are audited as part of each partner’s individual audit.
STREAMLINED AUDIT STRUCTURE
The Bipartisan Budget Agreement repeals the TEFRA and ELP rules and creates a streamlined structure for auditing partnerships and their partners at the partnership level. Generally, the IRS will examine the partnership’s items of income, gain, loss, deduction, credit and partners’ distributive shares for a particular year of the partnership (the so-called “reviewed year”). Any adjustments will be taken into account by the partnership, not the individual partners, in the year that the audit or any judicial review is completed (the so-called “adjustment year”) and will be collected from the partnership.
Differences: A comparison between the pre-existing partnership audit rules and the new law reveals several major differences:
- A partnership of any size (even those formerly classified as “small partnerships” with 10 or fewer members) is automatically subject to the new partnership audit rules unless it opts out;
- Opting out is limited to partnerships with 100 or fewer partners (rather than providing for an opt-in process for “small partnerships”); and,
- The new opt-out provision is limited to partnerships in which each of the partners is an individual, a C corporation (or qualifying foreign entity), the estate of a former partner, or an S corporation.
Further note that TEFRA rules did not allow an S corporation to elect-out as a small partnership. In addition, partnerships that opt out will be audited under the general rules applicable to individual taxpayers.
Under the new audit regime and with the exception of an opt-out, a partner must file its return based upon the partnership’s return, unless a notice of inconsistent position is filed at that time. Any subsequent challenge will not be considered valid.
Partnership representative: Under the new law, the TEFRA “tax matters partner” is replaced by a “partnership representative.” Powers and responsibilities are different. A partnership representative has complete and sole authority to act on behalf of the partnership, to bind the partnership and, consequently, all partners. Only the partnership representative may seek judicial review. The partnership may designate its partnership representative or, in default, the IRS may
do so, presumably under procedures to be determined.
“Adjustment year:” The major change in the partnership audit procedures involves the IRS’s ability to assess liability on the partnership for a “reviewed year” in the current “adjustment year.” Generally, the IRS will examine the partnership’s items of income, gain, loss, deduction, credit and partners’ distributive shares for the so-called “reviewed year.” Any adjustments will be taken into account by the partnership, not the individual partners, in the year that the audit or any judicial review is completed (the so-called “adjustment year”).
Amended return/adjusted Schedule K-1 options: The new partnership audit rules essentially shift the burden for any additional tax liability from the partners in the reviewed year to current partners. To change this result, individual partners must file amended returns for the reviewed year. In addition, the partnership representative will have 270 days to file information with the IRS to modify the amount of the “imputed underpayment.” After receiving a Notice of Final Partnership Administrative Adjustment, the partnership may also irrevocably elect to issue adjusted Schedule K-1s to reviewed year partners. Those reviewed year partners, however, will be required to take the adjustment into account in the adjustment year, plus interest.
One bit of good news: A provision that would have made a partner subject to joint and several liability for partnership-level liabilities was scrubbed from the language of the final version of the new law.
RESPONSE
Since the new partnership audit rules for the most part do not become effective before 2018, it does make sense for most partnerships to sit tight over the next year to see what IRS guidance will be forthcoming, as well as what planning techniques might be developed by practitioners in the interim. Although most partners and partnerships will not want to accelerate the 2018 effective date, the new law does provide that partnerships may elect to apply the changes (except for the opt-out rules for small partnerships) to returns of partnerships filed for partnership tax years beginning after Nov. 2, 2015. There again, patience in not moving forward immediately (in short tax-years or otherwise) makes sense absent IRS guidance.
Once the Treasury and the IRS firm up the new partnership audit rules, revision of partnership agreements should be considered. Revision of a partnership agreement should, among other things, consider gaining initial consensus among the partners on:
- Opting in or out;
- The selection of a partnership representative;
- The steps that the partnership representative may take with respect to an adjustment year; and,
- The structuring of necessary disclosure and indemnity agreements when interests change by sale or otherwise.
Although the new partnership audit rules arrived as something of a surprise for most taxpayers, there is the expectation that much of the uncertainty surrounding their implementation will be resolved well before the 2018 effective date critical to most partnerships. Nevertheless, this change represents one of several steps that Congress and the IRS are taking, by statutory change, regulations or otherwise, to reign in partnership “tax abuses,” whether caused by aggressive allocations and the like, or hiding behind the complexity of audit procedures. Partnerships should expect more of the same from Congress and the IRS in the future.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at Wolters Kluwer, CCH Tax and Accounting.
