The Bipartisan Budget Act of 2015 (the “Act”) replaced the existing partnership audit rules with a dramatically different set of rules that will be applicable to the first partnership tax year beginning after 2017. For calendar year partnerships, these rules will be effective for the 2018 tax year. The new rules are complicated and have numerous exceptions and special rules. The purpose of this article is to highlight the major changes and the impact of those changes on transactions with partnerships occurring before the rules become effective. Many partnerships will find it helpful to amend their partnership agreements well in advance of 2018. All references in this article to partnerships include limited liability companies that are taxed as partnerships and all references to the partnership agreement also apply to the operating agreement of a limited liability company.
A partnership is not a taxable entity—all of its income and loss is allocated through to its partners and the partnership items are included in the calculation of each partner’s tax liability. Under current rules, if the IRS audits a partnership tax year, any adjustment is allocated to the persons who were partners during the year to which the adjustment relates. For example, if the IRS were to audit a partnership’s 2013 tax return and increase its taxable income, that increase in income would be allocated to the persons who were partners in the partnership during 2013 and would increase the tax liability shown on their 2013 tax returns. Under the new rules, all of the adjustments are made at the partnership level and any tax, penalty and interest that is determined to be due is owed by the partnership. The amount of the tax due is determined by applying the highest marginal tax rate for individuals or corporations for the tax year under audit. The partnership will be obligated to pay the tax due plus any applicable penalties and interest. Since these amounts are due at the conclusion of the audit, those persons who are partners at the time of the audit will bear the cost of the tax, penalty and interest, even if they were not partners during the year to which the adjustment relates. A Partnership should consider including a provision in its partnership agreement to obligate former partners, or partners whose interest has been reduced, to make a payment to the partnership to reimburse it for the former or reduced partner’s share of the additional tax.
The new partnership level liability for the tax, penalty and interest is reduced if a partner files an amended return and pays the resulting tax. Additionally, the IRS is authorized to issue regulations to establish a process by which the partnership can prove that lower marginal tax rates should apply to the amount of the adjustment because, for example, some of the partners were tax exempt entities, individuals subject to lower effective tax rates on capital gain or qualified dividend income or corporations subject to a lower tax rate. The IRS has also been given the authority to provide through regulations a process to establish that a lower tax rate should apply as a result of a partner’s individual tax attributes, such as a net operating loss. The burden of proving that a lower tax rate should apply falls on the partnership, which means the partnership will need access to information about the individual partner’s tax situation in order to substantiate a lower effective tax rate. Partners should consider whether it is appropriate to amend their partnership agreement to include a mechanism to compensate partners who report their share of an audit adjustment on an amended return thereby reducing the partnership level tax liability or to require the partners to provide information about their personal tax attributes upon request so the partnership can use that information to try to reduce the effective tax rate on the partnership level assessment.
If the audit results in a net increase in losses, deductions or credits for a year under audit, the benefit of those items passes through to the persons who are partners in the year the audit is finalized, not those who were partners during the year under audit. However, the partnership will have the option to amend its returns and report the increase in losses, deductions or credits for the applicable year so that the benefit of those items will pass through to the persons who were partners during that year.
There are exceptions to this new partnership audit regime. First, if a partnership has 100 or fewer partners and all of the partners are individuals, corporations, estates of deceased partners or foreign entities taxable as a corporation, the partnership can elect out of the new rules. For purposes of the 100 or fewer rule, if a partnership has one or more S corporations partners, the number of shareholders who receive a K 1 from the S corporation are included. Unless permitted under future regulations, a partnership with partnerships or trusts as partners will not be eligible to elect out of the new partnership audit regime.
Additionally, a partnership can avoid the partnership level liability for the tax, penalty and interest that is applicable to an adjustment by making an election within 45 days of the date that a notice of final partnership adjustment is provided by the IRS to the partnership. If the election is made, the partnership must provide to the IRS and to each person who was a partner in the year under audit a statement of the partner’s share of any adjustments. The tax liability of those partners for the year in which the notice of adjustment is provided is increased by the increase in tax that would have been payable if the adjustment was made to the year under audit. For example, if a partnership receives a final notice of adjustment in 2020 with respect to an audit of its 2018 tax return and the partnership makes this election, each person who was a partner in 2018 will increase his 2020 tax liability by the amount that his 2018 tax would have increased had his 2018 tax return been amended to reflect the partnership adjustment. Increasing the partners’ tax liability for the tax year during which the audit is concluded eliminates the need to file amended tax returns; however, the amount of the tax adjustment is calculated by reference to the earlier tax year. Additionally, the interest rate payable on the amount of the tax adjustment will be two percentage points higher than the interest rate that would have been paid by the partnership had the election not been made.
The new partnership audit rules will also impact the level of diligence required to be performed if an interest in a partnership is being acquired and the terms of the transaction between the seller and buyer of the partnership interest. Prior to the adoption of these new partnership audit rules, there was little risk to the purchaser of a partnership interest with respect to the past “tax sins” of the partnership because if a period prior to the date of acquisition was audited, any resulting tax, penalty and interest would have been the obligation of those persons who were partners during the year under audit. Now, the tax penalty and interest is the obligation of the partnership. As a result, the purchaser should perform additional diligence to review the tax filing positions of the partnership and should seek contractual indemnification from the seller of the interest to protect the purchaser if the partnership incurs a cost as a result of an audit of a prior tax year.
As indicated above, the new partnership audit rules are a dramatic departure from those that have been in place for many years. There is more to be learned as the Treasury Department issues regulations providing much needed detail regarding the elections, special rules and exceptions that are authorized in the Code.