Radical changes in the law governing IRS income tax audits of tax partnerships (“New Partnership Audit Rules”) are generally effective for tax years beginning after December 31, 2017. Although there are many uncertainties regarding the rules and it will be some time before 2018 tax returns are filed (much less audited), all tax partnerships and their partners should review and amend their partnership agreements or limited liability company agreements as soon as possible in preparation for the new rules. The discussion below highlights some significant aspects of the New Partnership Audit Rules and the agreement drafting issues they raise. It then provides background regarding the development of the rules and the current status of proposed legislative amendments to the rules and proposed regulations interpreting the rules.
Highlights of the New Partnership Audit Rules
The partnership is represented in all income tax proceedings (including audits and litigation) only by its “partnership representative,” which has much greater power than does the “tax matters partner” under current law. Partners have no right to
receive notice of partnership tax proceedings, participate in partnership tax proceedings, or challenge the final results of partnership tax proceedings. The default rule is that taxes, interest and penalties resulting from a tax proceeding are collected from the partnership itself, rather than from the partners. This rule: is a radical change from current law, which instead requires each partner’s tax liability resulting from the partnership level proceeding to be separately determined and collected only from that partner, may lead to the collection of a tax from the partnership that substantially exceeds the tax that would be due if the tax liability was calculated and collected at the partner level, may cause partners who acquire their interests after the year under audit and before the tax is collected to bear the burden of taxes properly allocable to their predecessor partners, may cause all partners to bear the tax burden on gains recognized by one of the partners in connection with an asset contribution, calculates the partnership level tax liability using tax maximizing assumptions that can in some cases be overcome by providing information regarding the tax status of one or more partners, can be avoided through a number of means, including an election to “push out” the tax liability from the partnership to its partners, but the scope of the push out right is unclear, and the IRS has threatened to take a very restrictive view of its scope (e.g., questioning whether the liability can be pushed out through multiple tiers of partnerships). Partnerships with 100 or fewer partners with permitted tax classifications (e.g., no pass-through entity partners, subject to special rules for S corporations) can elect out of the New Partnership Audit Rules and require the IRS to instead audit partners individually.
High-Level Drafting Considerations
Tax partnerships should consider amending their partnership agreements or limited liability company agreements prior to January 1, 2018, to address, at a minimum, each of the points highlighted above, including the addition of provisions regarding:
selection and removal of the partnership representative (and the “designated individual” who acts on behalf of a partnership representative that is an entity, if applicable), duties of the partnership representative and the designated individual, limitations upon the actions of the partnership representative and the designated individual, rules for determining whether and when the partnership will seek to avoid collection of the tax at the entity level, including through an election to “push out” any tax liability, duties of partners to provide information or take action that reduces the partnership level tax liability or, if applicable, permits the partnership to “push out” or otherwise shift the tax liability to the partners, rules for maximizing the eligibility and ability of the partnership to elect out of the partnership level audit rules, and indemnities payable to or by partners, former partners, the partnership representative or the designated individual.
Development of the Pre 2018 Partnership Audit Rules
Tax partnerships are not subject to federal income tax. They allocate their income, loss and other tax items among their partners, who must take those allocated items into account in calculating their own tax liabilities. Prior to 1982, all income tax audits of partnership items occurred at the partner level.
In 1982, the “TEFRA” partnership audit rules were enacted to increase the efficiency of partnership tax audits and promote more uniform results among all partners. For partnerships subject to the TEFRA rules, income tax proceedings (including audits and litigation) are generally conducted at the partnership level, with the “tax matters partner” generally acting on behalf of the partnership. In many cases, however, the other partners have a right to receive notice of, participate in, and enter into separate settlement agreements with the IRS with respect to the partnership level proceedings. Once the correct amount and proper allocation of partnership items is resolved at the completion of the partnership level proceeding, the IRS is responsible for contacting the partners who owe additional tax and collecting the tax from them—not the partnership.
For certain partnerships with 10 or fewer partners, the TEFRA rules do not apply, so the IRS is required to conduct separate audits of each partner. At the other end of the spectrum, partnerships with 100 partners or more may elect into an audit regime that is still more streamlined than the TEFRA rules (though very few have done so).
IRS Problems with the Pre 2018 Partnership Audit Rules
The IRS has had a variety of problems working with the current TEFRA audit procedures, including difficulties identifying and working with the tax matters partner and collecting the resulting tax liability from the partners. These issues have been compounded by the growth in the number of tax partnerships, the increasing value of assets held through partnerships and the popularity and complexity of multi-tiered partnership structures. These difficulties have led to a low audit rate for large tax partnerships and a low level of IRS success in identifying and collecting tax deficiencies from the partners of those large partnerships that are audited.
Enactment, Amendment, and Potential Further Amendment of the New Partnership Audit Rules
A variety of proposals had been made in recent years to streamline the audit rules for large partnerships, including enabling the IRS to collect any income taxes resulting from the audit directly from the partnership. These proposals were viewed as revenue raisers because they were expected to allow the IRS to identify and collect substantially more tax underpayments.
To avoid a looming government shutdown, the Bipartisan Budget Act of 2015 was enacted on November 2, 2015. The New Partnership Audit Rules were one of the revenue raisers for that act. Some aspects of the New Partnership Audit Rules were drafted in haste, leading to a variety of ambiguities in interpreting the law.
Some of the ambiguities in the New Partnership Audit Rules were quickly clarified by the Protecting Americans from Tax Hikes Act of 2015, enacted in December 2015.
In December 2016, further corrections were proposed by the Tax Technical Corrections Act of 2016, including clarification of the ability of, and procedures for, tax liabilities to be pushed out through tiers of partnerships. That bill was not enacted in 2016 and has not yet been re-introduced in the current session of Congress. The prospects for its introduction and passage this year are unclear. At the moment, Congress is instead focused on broader tax reform.
The AICPA and the ABA Section of Taxation recently recommended that Congress amend the New Partnership Audit Rules to defer their effective date by one year—to tax years beginning after December 31, 2018—to allow Congress more time to amend the law, the IRS more time to draft regulations interpreting the law, and taxpayers more time to revise their partnership agreements in light of the revised statute and finalized regulations. The prospects for the introduction and passage of legislation that would implement that recommendation appear remote.
IRS Interpretation of the New Partnership Audit Rules
On August 5, 2016, the IRS published narrowly focused temporary regulations providing detailed rules for partnerships wishing to elect to become subject to the New Partnership Audit Rules for tax years beginning before January 1, 2018.
On January 18, 2017, the IRS released to the public the text of proposed regulations interpreting the New Partnership Audit Rules that it intended to officially propose through later publication in the Federal Register. However, as a result of a regulatory freeze imposed by the incoming Trump administration, this package was never formally proposed.
On June 13, 2017, the IRS released a 270-page package of proposed regulations interpreting the New Partnership Audit Rules. Except as discussed below, they are substantially identical to the proposed guidance that was frozen in January 2017. A hearing on the proposed regulations is scheduled for September 18, 2017.
The preamble to the frozen January 2017 regulation package stated that the IRS did not believe that the New Partnership Audit Rules could be interpreted to allow partnerships to “push out” tax liabilities through tiers of partnerships. This was a controversial position. Although the Preamble to the June 2017 regulation package details the IRS’ “significant administrative concerns” with permitting partnerships to “push out” tax liabilities through tiers of partnerships in explaining why the package reserves on this issue, it states that the IRS is actively studying the issue of when and how partnerships will be entitled to make the election to “push out” partnership audit level audit adjustments through tiers of partnerships and that it expects to issue additional proposed regulations on that point.
It is not clear when or in what form final regulations interpreting the New Partnership Audit Rules will be issued.
There are many uncertainties regarding the New Partnership Audit Rules. These uncertainties arise in part from the haste in which the rules were drafted and enacted by Congress, the failure of Congress to enact proposed technical corrections legislation, the lack of final regulations interpreting the rules, and IRS hesitance to read the new rules as allowing tax liabilities to be pushed out through tiers of partnerships. Since it will be some time before 2018 tax returns are filed (much less audited), taxpayers may be tempted to wait for some of these points to be resolved before reviewing and amending their existing partnership agreements or limited liability company agreements to take the new rules into account. However, it may be much more difficult for partners to reach agreement on these points once 2018 arrives. All tax partnerships and their partners should review and amend their partnership agreements or limited liability company agreements as soon as possible in preparation for the new rules.