On November 2, 2015, President Barack Obama signed into law the Bipartisan Budget Act of 2015 (the “Act”), which significantly modified how the IRS audits entities treated as partnerships for U.S. federal income tax purposes, including private equity funds, hedge funds, real estate, and other private investment vehicles.
The new partnership audit rules are effective for taxable years beginning after December 31, 2017, although partnerships may elect into the new rules earlier than the effective date. The new rules are intended to make it administratively less burdensome for the IRS to conduct partnership audits and collect resulting taxes, penalties, and interest attributable to any audit adjustments. It should be expected that the rate at which the IRS conducts audits of all partnerships, including private equity funds, will increase significantly under the new audit rules.
Current Partnership Audit Rules
Most partnerships are currently subject to audit rules adopted as part of the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”). Under these rules, the IRS conducts a single examination at the partnership level. If the IRS makes an audit adjustment, the partners during the tax year to which the adjustment relates are responsible for paying any tax due. Under the current audit rules, the IRS must flow the adjustment through to the ultimate partners. This can be complicated for partnerships with many partners and for partnerships in tiered structures where the IRS has to flow adjustments up through several levels before reaching the ultimate partners.
New Partnership Audit Rules
The new partnership audit rules will apply to all entities (including a flow-through limited liability company) treated as partnerships for U.S. federal income tax purposes, except for partnerships with 100 or fewer partners meeting certain requirements that affirmatively elect to opt out of the new audit rules. However, this “opt-out” election is expected to be unavailable for certain partnerships, including many private equity funds, because, in the absence of additional Treasury guidance, the “opt-out” election is not available for any partnership that has, as one of its partners, another partnership.
The new audit rules are intended to allow the IRS to more easily audit and assess taxes against large partnerships. To further this purpose, under the new partnership audit regime, the default rule provides that, if the IRS makes an adjustment at the partnership level, the IRS will assess and collect tax, penalties, and interest attributable to such audit adjustment at the partnership level. This is a significant departure from the existing TEFRA audit procedures, under which tax is assessed and collected from thepartners who were partners of the partnership in the year to which the adjustment relates.
Note that, under the default rule, because the partnership is directly liable for its partners’ tax liabilities (including penalties and interest, if applicable) resulting from an audit adjustment, the persons who are partners during the tax year in which the audit is finalized will bear the economic burden of the tax liabilities of any former partners from the tax year to which the adjustment relates.
To avoid liability at the partnership level under the Act, a partnership can elect an alternative procedure where the partnership will issue adjusted IRS Schedules K-1 to each partner who was a partner during the tax year to which the adjustment relates. This alternative procedure under the Act is similar to the existing TEFRA audit procedures in that the partnership-level audit adjustments flow through to the partners who were partners during the tax year to which the adjustment relates. However, under the alternative procedures, the resulting tax underpayment is subject to a two percent higher rate of underpayment interest, which underpayment interest does not appear to be tax-deductible.
Impact on Private Equity Funds
Although it will be several years before the IRS begins to conduct audits under the new partnership audit rules, existing partnership agreements, offering memorandums, subscription agreements, and side letters should be reviewed to determine whether any necessary or appropriate changes should be made to address the new audit rules. Specifically:
- Partnerships should decide whether they will elect to have the alternative procedure apply, and partnerships that meet the requirements for the “opt-out” election should decide whether such an election should be made.
- Offering memorandums should be updated to disclose the new partnership audit rules and resulting consequences, including that the partnership and its current partners may be liable for taxes that relate to prior years.
- Partnership operating agreements should be amended to designate a “partnership representative” that will act on behalf of the partnership for purposes of the new audit rules.
- Any partnership that has partners whose interests have changed over time, including private equity funds, venture capital funds, or other investment vehicles, should consider including in its partnership agreement general indemnity obligations whereby each partner and former partner agrees to indemnify the partnership for its appropriate share of any tax liabilities imposed on the partnership as a result of the default rule.
The new audit rules leave many issues unanswered. The IRS intends to issue significant guidance before the new partnership audit rules become effective.