Congress recently amended the rules governing tax audits of partnerships that file U.S. partnership returns, including U.S. partnerships (and limited liability companies treated as partnerships) and certain non-U.S. partnerships. The amended rules provide opportunities and challenges for both existing and new funds, and should be considered by both fund sponsors and investors. These new rules will generally apply to years beginning after December 31, 2017, although a partnership may elect to apply the new rules to years beginning after November 2, 2015.
Current Partnership Audit Rules
Currently, partnership audits are conducted under three different regimes depending on the number of partners in the audited partnership. Audits of partnerships with 10 or fewer partners are not conducted at the partnership level; instead, partnership items are effectively audited as part of the individual audits of its partners. A partnership with more than 10 partners is audited at the partnership level, with any audit adjustments resulting in redeterminations of the partners’ individual tax liabilities (and amended Schedules K-1 and partner tax returns) for the audited year(s). Finally, for a partnership with 100 or more partners that elects to be treated as an “electing large partnership,” any audit adjustments are generally taken into account by the partners on a current basis (i.e., in the year in which the audit is concluded), without adjusting any tax returns relating back to the audited tax year.
New Audit Rules
The new partnership audit rules replace these existing rules with a general regime and two noteworthy elective options, which are discussed below. Under the general regime, any adjustments to a partnership item (income, gain, loss, deduction or credit) will generally be taken into account in the year in which the audit is concluded, and any additional tax liability (including penalties and interest) will be assessed and collected from the partnership using the highest applicable tax rate (the “Partnership Level Tax”). A partnership under audit will have the option to submit partner-level information relating to the year under audit (for example, amended partner returns, tax rates applicable to certain partners or income allocated to those partners) to support a reduced Partnership Level Tax. As a result, persons who are partners during the year in which the audit is concluded will bear (indirectly) any additional tax liability attributable to the audit adjustments, irrespective of their actual ownership (if any) of the partnership during the year under audit.
Election Out of Audit Regime for Certain Smaller Partnerships
Certain partnerships with 100 or fewer partners may elect out of the new general audit regime. The election is filed with the tax return of the partnership and must be made for each year for which the election would apply. Notably, the presence of a partner that is itself a partnership (or a trust) will cause a partnership to become ineligible for this election. If an eligible partnership makes this election, certain procedural issues relating to an audit would need to be addressed directly by each individual partner. For example, the partnership would not be able to settle any audits on behalf of its partners and, instead, any settlement agreements or extensions of the statute of limitations must be agreed between each partner and the IRS. At the fund level (if the fund is eligible), sponsors may want to consider whether the benefit of electing out of the new general audit regime would outweigh the additional administrative burdens that may be placed on investors who would then need to separately manage audits or enter into settlement agreements with the IRS. For most portfolio companies, an investment by a fund would make them ineligible for this election.
Election Out of Current Year Liability
A partnership may opt out of bearing the new Partnership Level Tax if an election is made within 45 days of a final audit adjustment. If the election is made, any such tax liabilities would be borne by the persons who were partners during the year under audit, rather than the year in which the audit was concluded, without any requirement for the partnership or those partners to amend prior tax returns. However, this more streamlined approach comes at the cost of a higher interest charge (2% higher on any tax deficiency). A fund whose investors’ interests have not changed since inception may not want to make this election in order to avoid the higher interest charge. Funds where either investors or investors’ interests in the fund may have varied over the life of the fund (such as so-called “evergreen” or “perpetual” funds) may find this option more appealing, despite the higher interest charge, to protect current investors from bearing tax liability related to periods prior to such investor’s investment in the fund. Fund sponsors should also consider having a portfolio company make this election where interests held by any joint venture partners or management equity holders have changed since the investment was first acquired or where the audit relates to a period that precedes the fund’s ownership of such company.
The new legislation will also replace the existing “tax matters partner” designation rules with a “partnership representative” concept. This is a welcome development, as it will allow for the designation of a representative that will have authority act on tax matters who is not a partner in the partnership (currently a requirement for a tax matters partner). In particular, such flexibility would allow fund sponsors to designate the same management entity to serve as partnership representative for each of their funds; even in situations where, for business or regulatory reasons, it might not have been desirable or possible for such entity to be a partner. However, for existing portfolio investments, minority investors may seek to limit the authority of a partnership representative until more detailed guidance is issued on the scope of a partnership representative’s authority. Separately, it also is unclear how the requirement that the partnership representative have “a substantial presence in the United States” will impact fund structures that have non-U.S. general partners or managing members who currently act as tax matters partners.
Practical Considerations / Market Practice
We expect that forthcoming regulations will contain more detailed guidance (particularly in respect of the election to opt out of current year partnership liability and the appointment of a partnership representative).
At this time, partnership operating agreements should be updated to address how audits will be handled once the new rules become effective, including designation of the partnership representative and whether the representative will have broad authority to take actions with respect to audits (including making the elections described above). In addition, if neither of the elections described above would be desirable, the operating agreement could provide for the ability to specifically allocate or “claw back” any resulting Partnership Level Tax from persons who were partners during the audited tax year. It may also be worth considering whether withdrawing partners should agree to indemnify a partnership for any Partnership Level Tax for years during which they were partners, although this is likely to be more easily implemented for portfolio companies than at the fund level. Finally, for fund vehicles, disclosures in offering documents should be updated to reflect the new partnership audit rules, including whether any of the available elections will be made by the partnership.