On November 2, President Obama signed the Bipartisan Budget Act of 2015 into law, which brought sweeping changes to the partnership audit rules. The act repeals the substantive tax provisions and voluntary centralized audit procedures for electing large partnerships as well as the partnership audit procedures enacted in the Tax Equity and Fiscal Responsibility Act (TEFRA). In its place, a single system of centralized audit, adjustment and collection of tax is generally mandated for all partnerships. This new partnership audit regime will apply to partnership taxable years beginning in 2018, but the enactment of the new rules may warrant a current review of partnership agreements to analyze how the new rules will affect existing partnerships.
Under the new streamlined approach, any adjustments to tax items of a partnership and any partner’s distributive share of such adjustment will be determined at the partnership level. In a significant departure from prior rules, any tax attributable to such items will be assessed and collected at the partnership level. The IRS will examine the partnership’s tax items and the partners’ distributive shares for a particular year of the partnership (the “reviewed year”), but the adjustments will be taken into account in the year that the audit or judicial review is completed (the “adjustment year”).
The amount of tax (the “imputed underpayment”) paid by the partnership is calculated based on the net of all adjustments for any reviewed year and the highest individual or corporate tax rate. The rules provide that the imputed underpayment amount may be modified in circumstances in which the adjustment reallocates the share of a tax item from one partner to another. The purpose is to allow for partner-specific adjustments when warranted.
As an alternative to payment by the partnership, there is an opt-out provision allowing the partnership to provide each partner of the partnership’s reviewed year with a statement of the partner’s share of any adjustment. If the opt-out is made, the partners as of the reviewed year take the adjustment into account on their returns in the adjustment year. This opt-out provision shifts the burden, from the partnership to the partners, to pay any tax that is owed as a result of the adjustments. In addition, this alternative would insulate any adverse tax consequences to partners of the partnership in the adjustment year who were not partners in the reviewed year. Aside from providing a 45-day window to make this opt-out, the details on how it would be made have yet to be provided.
Additionally, the new partnership audit regime introduces a “partnership representative” concept in place of the “tax matters partner.” A partnership will designate a person with a substantial presence in the United States to act as the partnership representative who has the sole authority to act on behalf of the partnership. There are no current details on how the designation is to be made, but it is clear that, contrary to the prior regulations’ requirement that the tax matters partner be a partner, the partnership representative may be a non-partner third party.
Additional changes were made by the new law. A partnership may continue to file a request for an administrative adjustment for a partnership taxable year, but the resulting adjustment would be taken into account during the adjustment year. Further, the statute of limitations is determined from the date that the partnership return, not the partner’s return, was filed. In addition, notices of proceedings and proposed adjustments resulting from such proceedings will be mailed to the partnership and the partnership representative. The statutory language does not provide for such notices and adjustments to be sent to the partners.
There is a provision to elect out of the new regime in its entirety for certain partnerships with 100 or fewer partners if the partners consist solely of individuals, C corporations, foreign entities that would be treated as C corporations if domestic, S corporations, or estates of deceased partners. Interestingly, a partnership that has a partner taxed as a partnership is not eligible to elect out of these provisions. The election must be timely filed and include a disclosure of the name and taxpayer identification number of each partner, and the partnership must notify each partner of the election. After a successful election is made, the partnership would be audited under the general rules applicable to individual taxpayers. There are no current details from the IRS and Treasury on how this election is made, but the exclusion of partnerships that have partners that are partnerships is likely to preclude it as an option for many partnerships.
The Bipartisan Budget Act of 2015 introduces a new partnership audit regime that will have far-reaching effects, but there are many details that have yet to be developed by the IRS and Treasury. Below are our preliminary observations regarding the impact of certain provisions of the new law.
- If a partnership is eligible to elect out of the new rules in their entirety (because it has fewer than 100 partners of the required types), in most cases we believe such an election would be desirable. Partners should evaluate their partnership agreements to determine whether the partnership can be required to make such election if it is eligible to do so.
- In the absence of a complete election out of the new rules, consideration should be given to mandating in the partnership agreement the adoption of the opt-out procedures to shift collection of the tax to the partner level. This also would allow persons who were not partners in the reviewed year to avoid being adversely affected by any adjustments, since it shifts the burden to the reviewed year partners.
- To the extent that the imputed underpayment amount is determined at the partnership level, there are numerous issues presented by these rules, such as the extent to which different tax profiles of the partners (individual, corporate, tax-exempt) will be taken into account in a partnership-level determination.
- Collection of the tax from the partnership rather than the partners (if the opt-out procedure is not followed) is the salient change distinguishing these rules from the prior audit rules. Partners should consider specifying in their agreement how the economic cost of payment of such tax will be shared among them, including amounts paid on behalf of persons who are no longer partners, and newly entering partners may ask for an indemnity against such costs.
- Each partnership will need to give careful thought and consideration to what person will be the “partnership representative” since this person will have the sole authority on behalf of the partnership to enter into settlement agreements with the IRS. Partners should incorporate restrictions on the partnership’s representative authority in this regard in the partnership agreements, as well as set out clear parameters for partners to receive notice of all stages of tax proceedings.