The Bipartisan Budget Act of 2015, which was signed into law on November 2, represents a compromise between the Obama Administration and Congressional Republicans on raising the debt ceiling. The deal would raise the debt ceiling until March 15, 2017 (after the next presidential election) and increase authorized federal spending over the next two years by about $80 billion. Among the provisions that offset the cost of this legislation are two changes to partnership tax provisions. These provisions (i) will have a significant impact on the way partnerships are audited by replacing the current partnership audit regimes with a single, new regime, and (ii) will narrow the test for partner status by repealing Internal Revenue Code section 704(e)(1).
The new law repeals the existing partnership audit regimes for partnerships. Previously, under the Tax Equity and Fiscal Responsibility Act (TEFRA) rules, a single administrative proceeding was conducted for partnerships with more than 10 partners. Nevertheless, the IRS still had to assess any resulting tax adjustment against each of the partners from the year to which the adjustment related (i.e., the prior year under audit). For partnerships with 100 or more partners, special electing large partnership (ELP) rules applied. Under the ELP rules, partnership adjustments generally flowed through to the partners for the year in which the adjustment takes effect, rather than the prior year under audit. Although the ELP regime was enacted to mitigate the problems with TEFRA proceedings, few partnerships ever elected to use it.
The new law repeals these regimes for all partnerships, and it creates a single set of rules for a partnership-level audit for some, but not all, partnerships. In general, the rules would apply to partnerships with over 100 partners (with certain look-through rules, including counting shareholders of S corporations as partners for the 100-partner rule). Further, the rules would apply to any partnership that has another partnership as a partner, which should dramatically increase the number of partnerships subject to this new regime. While the rules technically apply to all partnerships, most partnerships with 100 or less partners (including S corporation shareholders for these purposes) can opt out of this regime.1 This election to opt out must be made on an annual basis.
The law establishes a new regime in which audit adjustments for a partnership that related to prior years can lead to an assessment payable by the partnership (rather than the partners) and payable with respect to the current year (not the prior years under audit). Unlike the TEFRA regime, only the partnership may request a refund, and the partners do not appear to have the right to participate in the partnership-level administrative proceedings. In addition, the IRS does not have to give notice of the administrative proceedings to the partners.
There are mechanisms for partnerships subject to this new regime to shift the burden to the partners, but the responsibility would be on the partnerships to act to engage those mechanisms. Rather than taking an adjustment at the partnership level, the partnership may issue adjusted Forms 1065 (Schedule K-1) to the partners (for the prior year under audit) who presumably would then take such adjustments into account at the partner level.2
Additionally, with respect to an adjustment initially determined only from partnership-level information, partnerships can use specific partner-level information to reduce such adjustment—for example different tax rates applicable to a given partner, amended returns by a partner, or the type of income at issue in the adjustment (e.g., ordinary, dividend, or capital gains).
This provision is similar to proposals by former House Ways and Means Chair Dave Camp in the Tax Reform Act of 2014 and by the Obama Administration in its 2015 revenue proposals (the “Greenbook”). The provision is intended to respond to IRS difficulty in making the audit adjustments of partnerships flow through to partners in order to assess the tax owed at the partner level, particularly when the partnership structure involved a number of tiers of partnerships.
Aaron Nocjar, a partner in Steptoe’s Washington office, commented, “The universe of partnership structures presently captured by the TEFRA or ELP rules will not be the same as the universe of partnership structures that may be covered by these new partnership audit and assessment rules. So, there will be current structures that were once covered by unified audit rules that no longer will be, and there will be current structures that had not been covered by unified audit rules that will now be so covered. Among other due diligence items, partnership agreements will need to be reviewed carefully to ensure that the original business expectations of the partners are preserved.”
All partnerships should be aware of the far-reaching effects of the new law. The law subjects potentially many more partnership structures to this new audit regime, and even those that may be able to opt out will have to do so affirmatively every year. Pre-existing partnership agreements will need to be reviewed to account for several differences between the former partnership audit regimes and the new regime, including whether and how to address partner reimbursement of partnership-level tax liability when partners are otherwise insulated from partnership-level liability under state law (e.g., a typical state-law LLC or LLP structure).
Because of the complexity of these changes, implementing these provisions will require detailed regulations from the IRS. Public input will be essential to identify areas of concern and ways to make the rules function properly.
This new regime addresses some of the difficulties the IRS has faced in auditing partnerships in the past, which suggests that it will result in a significant increase in the number of partnership audits. However, to give taxpayers (and the IRS) time to adjust to the new rules, the provisions will be generally delayed for two years. The new regime will apply to returns filed for partnership tax years beginning after 2017, unless a partnership affirmatively elects to apply the new rules to 2016 or 2017 tax years.
Determination of Partner Status Narrowed
The new law also makes changes regarding the analysis to be used to determine whether a person constitutes a partner of a partnership. Specifically, the new law repeals section 704(e)(1), which provided that a person be treated as a partner of a partnership if the person had a capital interest in such partnership and capital was a material-income producing factor of such partnership, regardless whether any other facts supported partner treatment. The new law is aimed at undercutting taxpayer arguments that, under certain circumstances, section 704(e) overrides the common law general facts and circumstances test of whether a person constitutes a partner of a partnership. For example, in a prominent line of cases, the taxpayer had successfully argued in the district court that, under section 704(e)(1), a foreign bank should be treated as a partner rather than a creditor of the partnership.3
According to the Joint Committee on Taxation, these partnership tax provisions would generate an estimated $11.2 billion in additional revenue over the 10-year budget window.