- The Bipartisan Budget Act of 2015 includes a complete overhaul of the procedures that apply to IRS audits of partnerships, including limited liability corporations taxed as partnerships and their partners.
- The complete picture of the Act will become clear only following the issuance of Internal Revenue Service (IRS) regulations, however it will have a significant impact on low-income housing tax credit (LIHTC) transactions, and industry participants should anticipate and proactively address potential issues.
- Although the new rules generally apply to IRS audits of partnership returns for 2018 and subsequent taxable years, partnerships may affirmatively elect to have the new regime apply for the 2015 through 2017 taxable years.
The Bipartisan Budget Act of 2015 (P.L. 114-74) was signed into law on Nov. 2, 2015. The Act includes a complete overhaul of the procedures that apply to Internal Revenue Service (IRS) audits of partnerships, including limited liability companies (LLCs) taxed as partnerships and their partners. It also repeals the Tax Equity and Fiscal Responsibility Act (TEFRA) audit rules that have been in place since 1982 and the reporting and audit procedures for electing large partnerships in effect since 1998. The new audit procedures will impact both existing and future syndicated tax credit transactions. Unfortunately, while there is substantial uncertainty about how the new procedures will be implemented, it is clear that the Act will have a significant impact on low-income housing tax credit (LIHTC) transactions. Industry participants are therefore advised to anticipate issues and address them proactively for transactions currently being negotiated. In addition, amendments to existing transaction documents also may be necessary.
Because the Act provides only an outline of the new regime, significant issues and questions are unresolved. The Act also gives the IRS broad authority to issue regulations to implement the system. Thus, many questions raised by the Act impacting LIHTC participants will have no clear answers until regulations are issued and participants (especially investors) can evaluate the complete rules. This alert addresses some of the initial questions and is intended to raise awareness of the potential breadth of the impact of the Act.
Common LIHTC Questions
“I heard the new rules only apply to partnerships with more than 100 partners. That won’t be an issue for my LIHTC investments. Why are we talking about this?”
While the new rules include an “opt-out” election for partnerships with 100 or fewer partners (small partnerships), the default position is that the new regime applies to all partnerships. Most importantly, an opt-out election is not available to partnerships if another partnership is a partner, unless the IRS issues future guidance extending the election under such circumstances (a possibility that is expressly contemplated in the Act). It appears at least reasonably likely that future IRS regulations will allow a small partnership that is a partner in what otherwise would be a small partnership to opt out. However, as the law stands now, in a typical syndicated LIHTC tiered partnership fund structure, the election to opt out is not available for lower-tier partnerships.
Where a decision to opt out is made available, the partnership must make an affirmative election annually on a timely filed return and include appropriate information to help the IRS identify the partners. Thus, currently negotiated transaction documents should include provisions that require or allow the annual election if it is available. In addition, if it is clear that an investor does not want the new provisions to apply, it may be prudent to consider forming a single investor fund as a single member LLC, with the investor being the single member and the syndicator being the non-member manager.
“The new rules don’t apply until 2018. Don’t I have plenty of time to worry about this later?”
The new rules generally apply to IRS audits of partnership returns for 2018 and subsequent taxable years. However, partnerships may affirmatively elect to have the new regime apply for the 2015 through 2017 taxable years. For current partnerships, it is advisable to review whether the current tax matters partner (TMP) is required to seek consent prior to making such an election. It also is noteworthy that the TMP provisions in the Code were repealed by the Act. We describe this in more detail below, however existing partnership agreements will need to be amended to reflect the elimination of the TMP concept. Additional restrictions on general partner authority related to the new regime also may be addressed via amendments to existing partnership agreements. For deals closing in the near future, we advise that these issues be addressed in some reasonable fashion, taking into consideration the absence of IRS regulations.
“If my partnership can opt out under my current transaction structure, or the IRS issues regulations allowing tiered partnerships to opt out in the future, is there any reason I should not opt out?”
While the answer to this question will rely heavily on future IRS regulations, there are some potential benefits to the new regime. For example, under the new rules, if the IRS makes an audit adjustment, the partnership itself generally will be liable for the tax due. This is a significant departure from the long-standing tax principle that partnerships are “flow-through” entities that are not generally subject to entity-level tax. The Act is silent as to whether the partners are liable for an audit adjustment if the partnership still exists but is unable to meet its obligation (due to the partnership’s bankruptcy or insolvency). A legislative summary of the Act appears to indicate that partners would not be liable if the partnership is unable to make the payment. While this should be carefully monitored, it is difficult to imagine that this result was intended or will survive IRS clarifying regulations. Similarly, the new rules appear to provide that the statute of limitations generally is three years from the later of (1) the due date of the return without regard to extensions, and (2) the filing of the partnership’s tax return. Under prior law, the IRS applied the statute of limitations based on the last to expire of the partnership’s or each partner’s statute of limitations. For many LIHTC investors, the new regime would be a welcome change in this regard, as tolling agreements and other larger corporate considerations result in a considerably longer statute of limitations period.
“What are the rules that apply if my partnership opts-out?”
With the repeal of the TEFRA audit rules, presumably the partnership and its partners would be audited under the general rules applicable to individual taxpayers. It remains to be seen whether the IRS will address “small partnership” audit procedures though the regulatory process.
“If my partnership can’t opt out, or decides not to opt out, what is different about the new rules?”
Again, the complete picture will come into focus only following the issuance of IRS regulations. The most significant changes reflected in the Act are the following:
- Partner Representative Replaces TMP. As discussed above, the “tax matters partner” has been eliminated and replaced with the new concept of a “partnership representative.” The partnership representative need not be a partner. The partnership representative “shall have sole authority to act on behalf of the partnership” in connection with an audit. If the partnership fails to name a representative, the IRS may designate one. Under prior law, any partner generally had the right to participate in a partnership audit; under the new regime, it appears that only the single “partnership representative” will be permitted to participate. The partnership and all of its partners will be bound by actions taken by the partnership representative in the audit process. As a result, partners will want to consider carefully who will retain the right to designate the partnership representative
- Partnership-Level Taxation. As discussed above, the entity-level taxation of partnerships represents a significant divergence from established law. The partnership-level audit adjustment is determined without the benefit of partner-level tax items that could otherwise reduce the tax due on any adjustments. For example, it appears that the net operating losses of a partner cannot be used to offset any additional partnership income. Likewise, income that would be allocated under a partnership agreement to a tax-exempt partner may now be subject to taxation at the partnership-level. Further, the adjustment generally is calculated assuming the highest rate of tax in effect for the reviewed year. No deduction is allowed for the tax, interest or penalties paid by the partnership. The IRS is directed by the Act to promulgate regulations to establish procedures under which the imputed adjustment amount may be adjusted to reflect the realities of the partner’s tax positions
- Electing Out of Partnership-Level Taxation. Subject to regulations to be issued by the IRS, the new rules provide the opportunity to elect out of partnership-level tax and shift the burden to the partners after the notice of final partnership adjustment. The election must be made within 45 days of the final determination, and the partners must pay their distributive share of the adjustment, plus interest at a slightly enhanced rate. The ability to compel or forbid this election is likely to be a focus for LIHTC investors, although the importance of this issue will be driven by the regulations to be promulgated
- Adjustment Year. Under the new rules, the partnership takes into account audit adjustments in the taxable year in which the audit (or any judicial review) is completed—the “adjustment year.” All partnership and partner adjustments related to the audit are made in the adjustment year (with an enhanced interest rate applied). As a result, the new rules could shift the cost of an assessment of tax due to persons that are partners in the adjustment year, rather than a simple flow-through of adjustments to the partners who benefitted from the underpayment in earlier years. For investors seeking to exit a partnership, this may provide added comfort because subsequent audits would not impact the investor. For parties attempting to complete LIHTC secondary market transactions, this change will need to be addressed through risk allocation negotiations.
“What types of issues should I be discussing with tax counsel and my LIHTC partners?”
There are a number of key issues to monitor, consider and discuss with your partners. In addition to those noted above, consider the following key issues:
- Existing partnership agreements should be reviewed and amendments will need to be drafted to address aspects of the new rules, including:
- designating the “partnership representative” in place of the TMP
- determining the partner(s) that will control the decision to opt out of the new regime
- preventing assignments of partner interests to persons that would preclude the inability to opt out
- addressing payment of entity-level tax
- committing to making certain elections in the event of an audit adjustment
- addressing circumstances where partners agree to “adjusted information returns” in lieu of entity-level tax
- Negotiations will be necessary to determine the appropriate “partnership representative” and the contractual limitations on the authority of such representative.
- In secondary market transactions, parties acquiring partnership interests will need to consider their potential share of the partnership’s liability with respect to prior tax years if the partnership has not elected out of the new regime.
- The Act imposes an entity-level tax on partnerships, an entity that is not generally subject to tax. Many technical tax issues arise from subjecting partnerships to tax that will need to be considered.