Who Does this Effect and When?
The new rules primarily impact partnerships with more than 100 partners and will generally apply to partnership taxable years after December 31, 2017. A partnership may elect to apply the new rules to tax returns for partnership taxable years after November 2, 2015 and before January 1, 2018. Certain partnerships with 100 (or fewer) partners may opt to elect out of the new rules and instead be subject to audits at the partner level.
What’s Considered a Partnership?
For purposes of the new partnership audit rules, a “partnership” is defined broadly to include any entity treated as such for U.S. federal income tax purposes (including entities that elect to be treated as partnerships under the so-called “check-the-box” rules). Accordingly, these new audit rules potentially will affect any partnerships that file U.S. partnership returns, including U.S. partnerships (and limited liability companies treated as partnerships) and most non-U.S. partnerships with U.S. partners (either directly or indirectly through one or more tax transparent entities).
What Does This Mean?
The new rules replace the existing partnership audit regimes with a general regime and two noteworthy elective options:
- Under the general regime, audits of a partnership’s items of income, gain, loss, deduction or credit (including the partners’ distributive shares of those items) will occur at the partnership level, in a manner similar to the existing regime for electing large partnerships. However, unlike the existing regime, any adjustments will generally be taken into account by the partnership, instead of the individual partners, in the year in which the audit is concluded.
- Any additional tax liability attributable to the adjustments will be assessed and collected (together with any penalties and interest) from the partnership based on an assumption that the highest applicable tax rate should apply.
- A partnership under audit will have the option to submit partner level information relating to the year under audit (for example, amended partner returns, applicable tax rates applicable to certain partners or income allocated to those partners) to support a reduced adjustment. While such information may reduce the resulting partnership liability, it will not alter the requirement that the partnership bear such liability in the year in which the audit is concluded. As a result, unless allocated differently in the partnership agreement, persons who are partners during the year the audit is concluded will bear (indirectly) any additional tax liability attributable to the audit adjustments, irrespective of their interests (if any) in the partnership during the year under audit.
Tax Matters Partner to Partnership Representative
Going forward, the partnership representative will have sole authority to act on behalf of the partnership with respect to audits and partnership reviews. Future regulations will address the manner in which a partnership representative shall be designated, but it appears that the eligibility requirements will be more flexible than those currently applicable to tax matters partner designations. As amended, the statute will merely require that the partnership representative be “a partner (or other person) with a substantial presence in the United States.” Thus, the statute raises the possibility of designating a partnership representative who is not a partner in the partnership.
Who Should Opt Out?
Partnerships with 100 or fewer partners may opt out of the new general audit regime by making an affirmative election for each taxable year for which the partnership seeks to opt out of the new rules. Although similar to the existing regime for partnerships with 10 or fewer partners, additional conditions apply. Specifically, a partnership is eligible to elect out if:
- the partnership is required to furnish 100 or fewer statements under Section 6031(b) (i.e., Schedules K-1); and
- its partners consist solely of individuals, C-corporations, S-corporations, foreign entities that, if domestic entities, would be treated as C-corporations, and estates of deceased partners.
If an eligible partnership makes this election, certain procedural issues relating to an audit would need to be addressed directly by each individual partner. It should be noted, however, that this more streamlined approach comes at the cost of a higher interest charge.
While we expect that forthcoming regulations will contain more detailed guidance (particularly in respect of the election to opt out of current year partnership liability), a few steps should be taken now.
- Partnership agreements of existing partnerships should be updated to address how partnership audits will be handled once the new rules become effective, such as who will designate (or be designated as) the partnership representative.
- Consideration should be given to whether the partnership representative will be given broad authority to make all available elections
Although many aspects of the new rules require further clarification, what is clear is that these rules will significantly change the administration of partnership audits. Even though these changes generally will not take effect until after December 31, 2017, partnerships and their partners should start preparing now. Certainly, drafters of new partnership agreements and LLC operating agreements should consider including provisions with respect to the new rules. Moreover, a determination will need to be made as to whether existing partnerships and LLC operating agreements should be amended in light of the new rules and, if so, how and with what implications (for example, in terms of required consents).