On November 2, 2015, the Bipartisan Budget Act of 2015, (the Budget Act) was enacted, which contains new rules for partnership tax audits. The Budget Act repeals the Tax Equity and Fiscal Responsibility Act (TEFRA) audit rules which were originally enacted in 1982 and the reporting and audit procedures for electing large partnerships in effect since 1998. It adopts new audit rules and procedures effective for partnership taxable years beginning after December 31, 2017. The purpose of the new streamlined partnership audit procedures is to increase tax collections from partnership audits, and accordingly, it is likely that as a result of the enactment of the new rules, the number of partnership audits will generally increase.
The new audit procedures will be applicable to all partnerships other than partnerships with 100 or fewer partners meeting certain requirements. Partnerships with 100 or fewer partners who are individuals or corporations may elect out of these rules provided they make an election on their information returns and provide certain information about all partners and S corporation shareholders. Accordingly, it is important to note that this “opt out” election is not expected to be available for fund structures because, as described above, the election is not available for lower-tier partnerships in tiered partnership structures (e.g., a fund partnership with a general partner entity taxable as a partnership or with a fund of funds taxable as a partnership as an investor).
Under the new rules, assessments for underpayment of tax will be determined and made at the partnership level (following an adjustment to the partnership’s income, gain, loss, deduction or credit) and payment of tax (including interest and penalties) will be made at the partnership level. Such tax liability will be determined without the benefit of partner level tax items that could otherwise reduce tax due on any adjustments. In general, assessments will be paid by the partnership in the year of adjustment. Further, reallocations of income from one partner to another (e.g., from the general partner to the limited partners) will result in a partnership level assessment of tax based on the increase in income to one partner or group of partners without taking into account a reduction in income allocated to the other partners. As is the case for federal income taxes more generally, payments made by the partnership under the new rules will be non-deductible. Partnership level assessments of tax due to adjustments of partnership items is a significant change in current law. It could shift the cost of any assessment to those persons that are partners in the year of assessment, rather than flowing the adjustments through to the partners who benefitted from the underpayment in earlier years.
The amount of any tax will generally be computed based on the highest tax rate applicable to an individual, but a partnership may claim a reduction based on certain types of income (e.g., capital gains and qualifying dividend income) and each partner’s status (e.g., individual, corporate, tax-exempt or foreign). For investment funds, special allocation provisions may be required to equitably charge the assessment to the domestic feeder for additional income that is not taxable to the offshore feeder or to reflect a reduced tax rate on capital gains or qualifying dividend income for individual investors. If an assessment results in a net reduction of income, increase in loss or change in credit, such adjustment will flow through to the partners in the year of assessment rather than result in a potential refund to partners for the taxable year under review. Also, partnerships generally will be precluded from filing amended tax returns and instead will be required to file administrative adjustment requests, which effectuate adjustments only in the year the request is submitted.
Subject to rules and procedures to be promulgated by Treasury, partnerships will be permitted to elect to have the assessment made against the partners of the partnership in the year under review by providing a list of all such partners during the taxable year to which the assessment relates and their share of such adjustments. Each partner will be required to take into account such adjustment at the partner level and pay additional tax for the current year based upon the taxes that would have been due for prior years as a result of the adjustment, along with interest at a special increased rate and any penalties due. Such election must be made within 45 days of final notice of partnership adjustment, which will follow the audit and any appeals process.
The new rules provide that the statute of limitations is generally three years from the latter of the due dates of the return without regard to extensions, or the filing of the partnership’s tax return. This is a positive change from current law where the IRS applied the statute of limitations based on the last to expire of the partnership’s or a partner’s statute of limitations.
The new rules replace the concept of “tax matters partner” with a partnership’s designated “partnership representative” that may be a partner or other person, in each case with a substantial presence in the United States. The partnership representative will retain broad authority to resolve any partnership audit and any such resolution will be binding on all partners. Following the effectiveness of the new rules, partners will no longer have a statutory right to notice or to participate in the audit proceeding.
In light of the new partnership audit rules, asset managers should consider:
- Adding new disclosure in fund offering documents;
- Modifying allocation provisions;
- Identifying a partnership representative; and
- Committing to make certain elections in the event of an audit adjustment.