The Bipartisan Budget Act of 2015 (the “Act”), which was signed into law on November 2, will drastically change the way entities (including limited liability companies) treated as partnerships for U.S. federal income tax purposes are audited by the Internal Revenue Service. The Act is expected to increase audit rates by making the procedures more manageable and efficient for the IRS, but in so doing it creates new issues that partnerships will have to carefully navigate. Perhaps the biggest change presented by the new audit rules is that any tax liability resulting from an audit adjustment will be imposed on the partnership itself rather than the partners, unless the partnership affirmatively elects to pass the liability on to its partners.
The new rules will be not become mandatory until 2018, as they will only be required to apply for tax years beginning after December 31, 2017, so there is some lead time for partnerships to prepare for the new rules. In the meantime, the IRS and the Treasury Department will hopefully provide more guidance to fill in the unanswered questions created by the Act.
In addition to providing for the assessment of tax liability directly on the partnership for any deficiencies unless the entity makes an election to have the adjustments shifted to the partners, the Act provides that such partnership liability will be taxed at the highest applicable rate then in effect. These new rules will apply to all partnerships, although partnerships that meet two criteria may elect out of the regime: those that (1) have 100 or fewer partners and (2) do not have any partnerships or trusts as partners. Audits and adjustments relating to partnership items would take place at the partner level if a partnership elects out of the new rules, as under current law.
The current partnership audit regime contains three different sets of procedures, the application of which depends on the size of the partnership (with different procedures for partnerships with 10 or fewer partners, with more than 10 partners, or electing partnerships with at least 100 partners). Under all of those current procedural structures, the tax is assessed at the entity level and the liability imposed on the partners. The new law is intended to streamline the audit process for the IRS, which has historically maintained a very low rate of partnership audits due to the complexity of the process in light of the agency’s budgetary constraints. Therefore, it is expected that the rate of partnership audits will substantially increase under the new rules, which would seemingly lead to more taxes being collected and thus make the new law a revenue-raiser for the federal government.
The Act does give a partnership an alternative to entity-level liability for tax adjustments. Rather than have the default regime apply, a partnership may elect to furnish adjusted Schedules K-1 to the partners and to the IRS, stating each partner’s share of any partnership adjustments. Those partners would then take the adjustments into account on their own tax returns in the year in which they receive their adjusted Schedules K-1 (rather than by amending their returns for the reviewed year). They would also incur a two percent increase on the interest rate on their underpayment of taxes. The election to utilize the alternative method must be made within 45 days after the notice of final partnership adjustment has been issued by the IRS.
Note that the new rules are not entirely clear regarding a situation where a partnership (the “upper-tier partnership”) owns an interest in another partnership (the “lower-tier partnership”), and the lower-tier partnership has elected out of the default regime and so passes on the tax liability to its partners, including the upper-tier partnership. In such a situation, further guidance is needed as to whether the upper-tier partnership can issue adjusted Schedules K-1 to its existing partners as of the year under audit for the lower-tier partnership. If the upper-tier partnership cannot do so, then its partners as of the year of the pass-through of the lower-tier partnership adjustment would in effect be responsible for the taxes, even though such partners may be different from the partners in the lower-tier partnership for the year under audit.
The Act eliminates the concept of “tax matters partner” and instead requires a partnership to have a “tax representative” who will assume sole authority to act for the partnership in an audit. Requirements under current law mandating notification to partners of certain entity-level activity and partner rights to participate in entity-level proceedings are repealed by the Act, and the tax representative will have full authority to settle tax proceedings that can affect all partners. Unlike the tax matters partner, the tax representative does not have to be a partner, but must have a substantial U.S. presence. On a positive note, the Act resolves the oft-confusing issue regarding who can serve as the tax matters partner for a limited liability company under current law.
For a partnership that wants to elect out of the new regime and is able to qualify due to having 100 or fewer total partners that do not include any partnerships or trusts, an election must be made annually on its partnership return. Further, all partners must be notified of the annual election out of the default audit procedures, and the partnership must report to the IRS the name and taxpayer identification number of each partner. The reporting requirements include each shareholder of any S corporation that is a partner, and each such S corporation shareholder counts toward the 100-partner limit for the partnership to be eligible to elect out of Act’s default procedures.
The Act obviously creates numerous items for partnerships to consider and take into account going-forward. Partnerships that are allowed to elect out of the new procedures will have to analyze the pros and cons of the old rules versus the new rules and decide which set is better for their particular circumstances. Partnerships that are under the new set of rules will need to address many aspects of the Act in their partnership or operating agreements, including replacing the tax matters partner provisions with provisions applicable to a tax representative and addressing whether the partnership elects to bypass entity-level tax liability and instead pass any audit adjustments on to its partners (or at least address how such election will be made).
By imposing tax liability on the partnership itself, the Act will also greatly impact the negotiation and drafting of partnership acquisition and subscription agreements. Provisions for pre-closing period tax indemnification, control of audit proceedings, and audit/tax elections for pre-closing periods will take on much more significance. Lastly, partnerships will have to analyze the state and local tax implications of the new audit rules set forth in the Act.