Effective for partnership tax years beginning after 2017, the Bipartisan Budget Act of 2015 repealed the current partnership audit rules and replaced them with rules described in general terms below. Partnerships can also elect to apply the new rules sooner to partnership tax years beginning after the date of the Act’s enactment. In brief, the major change is that the partnership itself can be liable for federal income tax in the tax year the audit adjustments become final. The partners in that year bear the economic burden of the tax and not the partners in the earlier tax year under audit and with respect to which the adjustments are made. Since partnerships can elect to apply these new rules earlier than 2018, some extra diligence is needed now in the acquisition of partnership and LLC interests.
References to a partnership and its partners include references to an LLC and its members for an LLC taxed as a partnership for federal income tax purposes. A partnership is not a taxable entity. Instead, a partnership’s items are allocated to its partners and taken into account by them on their tax returns. If those partners are themselves partnerships, the items are further allocated among the partners of these partnerships so that ultimately the items are taken into account by an individual or entity subject to federal income tax. Under current law, when the IRS audits partnerships, it has to notify most partners of the audit and these partners have the right to participate in the audit. Adjustments of partnership items are made at the partnership level. The IRS also has to allocate the adjustments among the partners and assess resulting income tax deficiencies. This procedure was administratively cumbersome for the IRS particularly with partnerships with many partners or those with partnerships as partners, i.e., tiered partnership structures. Also under current law, a tax matters partner on behalf of a partnership can contest IRS adjustments in court and if that partner does not do so, other partners can.
- All adjustments will be made at the partnership level, and assessment and collection of taxes, interest and penalties will also occur at the partnership level. The IRS will determine a net adjustment by netting all adjustments at the partnership level and multiplying a net positive adjustment by the highest tax rate for individuals or corporations for the tax year under audit. The partnership is liable to pay for the resulting income tax in the year the final adjustment is made along with interest and penalties. Payment of the income tax and penalties is not deductible.
- Partnership liability is reduced if a partner files an amended return and pays the resulting tax. IRS is directed to establish procedures to allow the partnership to prove lower tax rates should apply because of, for example, partners that are tax exempt or that are individuals subject to lower tax rates for capital gain or qualified individuals, or corporations subject to lower tax rates than individuals. The IRS has regulatory authority to permit other reductions in the partnership tax liability for reasons other than lower tax rates, such as reduction in a partner’s tax if the partner’s share of adjustment were allocated to that partner because of the partner’s individual tax attributes such as net operating losses. Partnerships would have to work out how to compensate a partner that either amends its return and pays tax or has a lower tax rate than other partners because their actions or status lowers the partnership’s tax bill for all partners. In addition, the ability to prove lower tax rates for the ultimate taxable partners puts the burden on the audited partnership to gain details about the status of indirect taxable partners with interests in certain trusts or partnerships which are not taxable entities, but which are direct partners in the audited partnership.
- If the IRS adjustments increase losses, deductions or credits for the year under audit, the benefit of those tax items appears to pass to the partners in the year of the adjustments not those partners during the year under audit for which the adjustments are made. On the other hand, if the partnership amends its returns and reports increases in losses, deductions, or credits for a particular year, the benefit of those tax items passes to parties who were partners during that year. The prior partnership audit rules allowed a partnership to file suit in court if the IRS disallowed an amended partnership return that would lead to tax refunds for the partners or failed to take any action with respect to such return. The Budget Act repealed those rules without substituting similar provisions. It is not clear what judicial action a partnership may take, if any, if the IRS does not allow in full any increased losses or deductions reported on an amended return or the IRS fails to take any action with respect to such return.
- The partnership will be required to designate one person or entity which has the sole authority to act on behalf of the partnership under the new rules. If the partnership fails to do so, the IRS has the authority to appoint a representative. The partnership and all partners are bound by the actions of this representative on behalf of the partnership. Only the partnership through the actions of this representative can contest proposed adjustments in U.S. Tax Court, a district court or the Claims Court. Unlike the old rules, the new rules do not specifically permit non-representative partners to participate in the audit but they do not prohibit it either.
- For tax years beginning after 2017, the statute allows certain partnerships to elect not to have these new audit rules apply. Eligible partnerships that can make this election must not have more than 100 partners and the partners must all be individuals, corporations, estates of deceased partners or foreign entities taxable as corporations. Shareholders of subchapter S corporations that are partners are counted as partners and the election must disclose their names, addresses and taxpayer identification numbers. Unless IRS regulations provide otherwise, eligible partnerships cannot have partnerships or trusts as partners. If this election is made, the normal audit rules will apply to each partner and not the former partnership-level audit rules which are repealed.
A major exception to partnership liability for audit adjustments is available. A partnership must elect this exception within 45 days after the date of a notice of final partnership adjustment is provided by the IRS to the partnership. If this election is made, and in the time and manner as the IRS provides in regulations, the partnership must furnish to the IRS and to each partner in the partnership for the year under audit a statement of the partner’s share of any adjustments. Each partner’s tax for the tax year in which the statement is provided to the partner is increased by the increased income tax that would have been payable by the partner if taken into account for the earlier audit year. There are no statutory provisions that allow a partner to contest the amount of the allocation in the statement provided by the partnership to the partner. Penalties will be determined at the partnership level and the partners for the audit year or the year with respect to the adjustments are made are liable for the penalty. Partners will also owe interest on any increased tax as if it were due for the earlier audit year. The interest underpayment rate is two percentage points greater than the normal rate.
It is not clear how this exception will operate if the partnership making the election has one or more partnerships as partners, because these partnerships might not be able to elect this exception under the statute; in this case, any partnerships that are partners of an audited partnership making this election would likely have to pay income tax as a result of the adjustment.
Another proposed version of similar legislation required the electing partnership to ensure that each of its partners in the prior year took the adjustment into account and paid the resulting tax. The version enacted contains no such requirement.
The rules above are general descriptions of specific, but not all, areas of the new rules. Regulations will have to provide detailed guidance on many areas including, but not limited to, how to handle adjustments for a dissolved partnership. These new rules will also lead to many new provisions in LLC agreements and amendments of existing agreements to, among other things, designate a method for selecting a partnership representative; seeking indemnification from withdrawing partners; spelling out whether certain tax elections will be made; how payment of the tax by the partnership impacts the partners’ capital accounts; whether compensation will be paid to partners whose tax attributes reduce the partnership’s tax liability to the benefit of other partners; whether capital contributions will be required to pay tax liability; requiring partners to cooperate and disclose tax information including that of the partners of a partnership that is a partner of an audited partnership; and possibly prohibiting trusts and partnerships from becoming partners in the partnership so the partnership can elect not to have the new rules apply.