First published by the American Investment Council, September 28, 2017
The subtleties of the tax audit and litigation process are usually only interesting to tax controversy professionals. So, saying that the partnership tax audit process enacted under the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”) was repealed and replaced with a new process under the Bipartisan Budget Act of 2015 (“BBA”) is an almost surefire way to lose a reader’s attention.
Let’s try it this way instead — your funds are about to be in danger of having to pay tax themselves. This means that your current investors may be forced to bear the tax cost for income allocated to prior investors. And, if that isn’t bad enough, the amount of the tax owed by the fund and borne by the current investors will likely be significantly higher than the aggregate tax that would have been paid by the prior investors under current law (i.e., TEFRA).
What has changed?
TEFRA currently provides for a unified audit and litigation process for the IRS to review and challenge tax issues relating to partnerships. The goal of this process is to allow the IRS to more efficiently raise partnership issues and to have a single determination by one court as to the correct outcome. However, once a partnership issue is decided, the IRS is left with the administrative obligation of identifying the partners, determining how much additional tax each owes, and collecting the additional taxes from those partners.
Under the BBA, there will still be a unified audit and litigation process for partnership issues. However, upon the conclusion of such a proceeding, the new default rule provided by the BBA is that any additional taxes are owed by the partnership, not its partners. This eliminates the administrative obligation imposed on the IRS under TEFRA to identify, calculate and collect tax at the partner level. In other words, the notion that the tax is “passed through” to the appropriate partner will no longer apply, and prior tax liabilities will follow the partnership, not the partners. This is a fundamental change that essentially shifts tax liabilities resulting from an IRS audit away from the former partners (i.e., partners in the partnership during the tax year being audited by the IRS) to the current partners (i.e., partners in the partnership during the year in which the IRS audit is resolved).
Notwithstanding this default rule, the BBA provides two alternatives where additional taxes owed as a result of a partnership adjustment can still be paid by the former partners. First, pursuant to the modification procedure described below, partners can file amended returns, pay the resulting additional taxes themselves, and provide affidavits to the IRS swearing that they have undertaken these steps.
Second, the partnership can elect to “push out” the adjustment, which requires the former partners to report in their current tax year (i.e., the one in which the dispute is resolved) the additional taxes owed as a result of the adjustment to the reviewed year. This avoids the necessity of filing amended returns and providing affidavits but comes with the price of a higher statutory interest rate being imposed on the additional taxes owed.
The key distinction between these two alternatives and the current process under TEFRA is that, under these new alternatives, it is not the IRS but rather the partnership and the partners that have to make the required identifications and calculations of additional tax.
Why was this changed?
Money. Congress estimated that the new process for collecting partnership underpayments under the BBA would raise an additional $10 billion in tax revenue over 10 years. Currently, the IRS’s audit rate for partnerships is lower than for corporations. Presumably at least part of this difference is due to the administrative obligations imposed on the IRS under TEFRA regarding partnership underpayments, and the belief is that the new BBA approach will help close that gap.
When does this change take effect?
The new BBA rules generally apply for tax years beginning January 1, 2018. That means certain issues (like whether to elect out of the BBA for partnerships that are so eligible and whom to identify as the Partnership Representative — both of which are discussed below) do not have to be resolved until the 2018 partnership return is filed in 2019.
What should I do now?
Although the new audit rules under the BBA are not effective until 2018 and despite the fact that Treasury continues to develop guidance with respect to the BBA, there are good reasons to address a number of BBA-related issues now in any new partnership agreements as well as in amendments to existing partnership agreements. A few of the more pressing issues are discussed below.
Election Out of the BBA
Partnerships with no more than 100 eligible partners and no ineligible partners may generally elect out of the new BBA regime. For these partnerships, the IRS will no longer benefit from the unified partnership audit and litigation process currently provided under TEFRA. Instead, the IRS must review and audit partnership issues for each partner separately. Partnerships that are eligible to elect out of the BBA will likely want to make that election. To that end, partnership agreements should be revised to clarify whether the partnership will (if eligible) elect out of the BBA.
Ineligible partners include partnerships, trusts, disregarded entities, nominees and other similar persons. Thus, partnerships that are currently eligible to elect out of the BBA may want to impose restrictions on transfers of partnership interests to ineligible partners since those transfers would invalidate the election.
Many private equity funds will not be eligible to elect out of the BBA either because they have ineligible partners (e.g., partners that are disregarded entities or are themselves partnerships) or because they have more than 100 partners.
With the repeal of TEFRA, partnerships will no longer have a Tax Matters Partner. Instead, there will now be a Partnership Representative. Unlike the Tax Matters Partner, the Partnership Representative does not have to be a partner and can be the partnership itself.
The BBA gives the Partnership Representative sole authority to resolve any partnership audit, and any such resolution will be binding on all partners. Partnership agreements should designate a Partnership Representative for the partnership. If no Partnership Representative is chosen by the partnership, the IRS will select one.
The Partnership’s Imputed Underpayment
As discussed above, the default rule under the BBA of allowing the IRS to collect any underpayment of taxes from the partnership effectively shifts the economic burden of those taxes from the former partners to the current partners. Partnerships should consider whether they want to include indemnifications of such liabilities by the former partners for the benefit of the current partners. If so, such provisions should be added now so that they will be enforceable against partners who dispose of their partnership interests in 2018 (the first taxable year for which the BBA takes effect).
Another consequence under the BBA’s default rule is that the amount of any underpayment owed by the partnership will almost certainly be higher than the aggregate payments that would be owed if the additional taxes were paid by the former partners. This is because the highest marginal tax rate then in effect is applied to calculate the partnership’s underpayment, without regard to whether the partners are individuals or corporations (or tax-exempt entities) or whether the partners in fact pay tax at the highest marginal rate. Furthermore, the calculation of the partnership’s underpayment amount is generally made only with respect to adjustments that increase tax (i.e., it disregards any corresponding adjustments that decrease tax). For example, if the adjustment reallocated $100 of partnership income from partner X to partner Y, the partnership’s tax underpayment would be calculated solely based on the increased tax owed by partner Y with no offset for the reduction in tax owed by partner X.
Modifications of the Partnership’s Imputed Underpayment
Recognizing that the default calculation of the partnership’s underpayment will be overstated, Congress and Treasury have provided procedures for the Partnership Representative to request modifications that reduce the amount of the underpayment. If the IRS accepts the factual support provided with the modification request, it should reduce the amount of the partnership’s underpayment based on those facts.
For example, to the extent the Partnership Representative can demonstrate that adjustments are allocable to tax-exempt partners, the IRS should agree to reduce the amount of the partnership’s underpayment. Also, to the extent that the partners file amended returns and pay the additional tax themselves (and swear to these facts), the IRS should again agree to reduce the amount of the partnership’s underpayment.
The “Push Out” Election
One alternative to the partnership paying any additional taxes owed as a result of an audit is the “push out” election that allows a partnership to push out a partnership adjustment to the former partners. This election will correctly align any additional tax liability to those partners that received the economic benefit of the underlying income. Partnerships should address the “push out” election in their partnership agreements. This election comes at a cost, however, with the BBA imposing a higher interest rate on tax underpayments that are “pushed out.” Critically for private equity funds, the IRS has yet to specify whether this election will be available for tiered partnerships (i.e., partnerships that have partners that are themselves partnerships) and, if so, how it will work in that context.
What does this portend for the future?
The BBA is extremely complex and addresses a significant number of other important issues. Further, several provisions of the BBA are unclear and will require additional regulatory guidance, if not statutory clarification.
It is clear, though, that Partnership Representatives will have to make difficult decisions in the future — often balancing the competing interests of former and current partners. These decisions will likely be controversial, and thought should be given today to putting partners on notice of these issues and protecting the Partnership Representative against the consequences of having to choose among nothing but bad options.