On Monday, November 2, 2015, the Bi-partisan Budget Act of 2015 (the Budget Act) was enacted. The Budget Act completely replaces and transforms the partnership audit procedures. Importantly, the Budget Act provides that absent an election, the partnership, and not the partners, will be required to pay any federal tax deficiency relating to partnership audit adjustments. The purpose of the new streamlined partnership audit procedures is to increase tax compliance by partnership, and, accordingly, it is likely that, as a result of the enactment of the new rules, the number of partnership audits will increase. The Budget Act will have significant implications for merger and acquisition transactions involving partnerships.
While the new rules are effective for taxable years beginning after December 31, 2017, a partnership may elect to apply these rules to partnership taxable years beginning after the date of enactment.
Under the existing audit rules, the partners of a partnership in the taxable year being audited, and not the partnership, are generally responsible for the payment of any tax deficiency. Therefore, purchasers of partnership interests do not bear the risk of pre-closing federal income tax deficiencies. Under the Budget Act, however, the partnership, not the partners, will be required to pay any tax deficiency resulting from a partnership level tax audit (subject to certain exceptions) and the tax due will be calculated at the highest marginal rate of tax and generally without regard to partner level items. This is a significant change from current law as it shifts the cost of any adjustment to the partners in the year in which the assessment is finalized rather than flowing through to the partners who benefitted from the underpayment in earlier years.
In lieu of the partnership paying a tax deficiency calculated as described above, the Treasury is directed to promulgate rules and procedures pursuant to which a partnership will be able to have adjustments resulting from the partnership level audit reflected, and paid by, the partners of the partnership during the years to which the audit relates (a Partner Assessment Election). If the Partner Assessment Election is made, those partners, and not the partnership, will be subject to the adjustments and assessment. The election can be made no later than 45 days after the date of the notice of final partnership adjustment, and once made, can be revoked only with the consent of the Commissioner. In addition to the foregoing election, partnerships issuing 100 or fewer Schedule K-1s may opt out of the new partnership audit rules entirely, with the effect that any audits relating to the partnership must occur at the partner level (the Small Partnership Election). In this regard it is important to note that the Small Partnership Election is not available for lower-tier partnerships in tiered partnership structures.
Under the Budget Act, the statute of limitations is generally three years from the later of the due date of the return (without regard to extensions) or the filing of the partnership’s tax return. The date on which a partner’s tax return is filed is no longer relevant with respect to a partnership audit, unless the Small Partnership Election is available and is made by the partnership or the partnership ceases to exist. The new partnership audit rules generally provide that adjustments to partnership items are made at the partner level with respect to partnerships that have ceased to exist prior to the effectiveness of a partnership audit adjustment.
The new rules under the Budget Act also replace the concept of “tax matters partner” with a “partnership representative” who may either be a partner or other person designated by the partnership, in each case, with a substantial presence in the United States. The partnership representative would retain broad authority to resolve any partnership audit and any such resolution would be binding on all partners. Partners will no longer have a statutory right to notice of, or participation in, the audit proceedings and will no longer be considered parties in any court proceedings.
The following initial observations on the Budget Act are relevant to the purchase or sale of partnership interests and to new and existing partnerships and other entities treated as partnerships for federal income tax purposes:
- Prospective purchasers of partnership interests may desire to request an indemnity from the seller for any losses suffered as a result of an audit or the imposition of tax on the partnership that relates to a pre-closing taxable period in case the partnership does not make, or is unable to make, a Small Partnership Election or a Partner Assessment Election. Prospective purchasers of interests should also consider requesting a representation that no election has been made, and no election will be made, to apply the new rules to taxable periods beginning before January 1, 2018.
- In light of the consolidation of control and statutory notice rights in the partnership representative under the new rules, potential purchasers of partnership interests should consider whether to request additional notice rights or control over the actions of the partnership representative and to require a partnership to maintain records sufficient to make Partner Assessment Elections with respect to all relevant periods.
- While the new rules state that, under regulations to be promulgated, partnership adjustments are made at the partner level with respect to partnerships that have “ceased to exist,” questions remain as to when a partnership has ceased to exist and how the regulations will apply to partnerships that become disregarded entities for federal income tax purposes.
- Partners in existing partnerships and parties considering the formation of new partnerships should consider the application of these new rules to their particular situation. They should consider, for example, whether to require the partnership to make the elections that are available under the new rules, especially the Small Partnership Election or a Partner Assessment Election, and consider adding control or notice provisions with respect to the actions of the partnership representative.