The U.S. Bipartisan Budget Act of 2015 amended the provisions of the U.S. Internal Revenue Code of 1986, as amended (Code), governing partnership audit proceedings. The new provisions are designed to simplify the ability of the U.S. Internal Revenue Service (IRS) to conduct audits of partnership tax returns and collect any resulting tax liabilities. Although signed into law on November 2, 2015, these rules generally will begin to apply to audits of partnership returns filed for taxable years beginning on or after January 1, 2018. The following discussion summarizes these rule changes and their implications for investment funds that are treated as partnerships for U.S. federal income tax purposes. It should be noted, however, that many aspects of these rules require clarification. Future regulations and possible amendments to the Code may alter the application of these new rules.
Summary of Rule Changes
Current Law Rules
Partnership audits generally are conducted as unified proceedings at the partnership level. A “tax matters partner” (typically, a general partner or managing member) acts on behalf of the partnership and (in general) its partners in such proceedings. Any resulting adjustments to partnership income or expense items may result in increased tax liabilities for those persons who were partners in the year under audit; such liabilities are not collected from the partnership pursuant to the audit proceeding, and instead must be collected at the partner level from the affected partners. Affected partners must file amended returns, reflecting amended Schedule K-1 information received from the partnership, for the audited year.
Exceptions to this general, unified approach are available to certain partnerships. Audits of certain eligible partnerships that have 10 or fewer partners1 are conducted at the partner level together with audits of a partner’s individual return, unless the partnership elects to be subject to the general, partnership-level rules for audit proceedings. In addition, for a partnership with 100 or more partners that elects to be treated as an “electing large partnership,” any adjustments resulting from an audit of the partnership are generally taken into account by the partners on a current basis (i.e., in the year the audit is concluded), without adjusting any prior year returns relating back to the audited tax year.
New Rules – in General
To facilitate the collection of tax by the IRS, the new partnership audit provisions generally will require partnership audits to be conducted at the partnership level, in a manner similar to the existing regime for electing large partnerships. Any resulting adjustments to partnership tax items generally will be taken into account by the partnership, rather than the individual partners, in the year in which the audit is concluded. Any additional tax liability attributable to the adjustments will be assessed and collected (together with any penalties and interest) from the partnership based on an assumption that the highest applicable tax rate should apply. A partnership will have the option to submit partner-level information relating to the year under audit (for example, amended partner returns, tax rates applicable to certain partners or income allocated to those partners) to support a reduced adjustment. While such information may reduce the resulting partnership liability, it will not alter the requirement that the partnership bear such liability in the year in which the audit is concluded. As a result, persons who are partners during the year an audit is concluded will bear (indirectly) any additional tax liability attributable to the audit adjustments, irrespective of their interests (if any) in the partnership during the year under audit.
Observation: Particularly for hedge funds and other investment partnerships that provide for redemptions or other liquidity opportunities for investors, the assessment of a partnership-level tax in the year in which an audit is concluded may lead to fundamental unfairness, given the likelihood that ownership changes will have occurred in the intervening period between the year under audit and the year in which the audit is concluded. Private equity and other closed-end partnerships may also be impacted, as ownership percentages may change due to investor defaults or exclusions from particular investments.
Observation: Regardless of whether an audited investment partnership has experienced ownership changes, an entity-level assessment regime can lead to consequences that defy fairness or simplicity. Consider the case of a tiered partnership structure (for example, a common fund of funds or master-feeder structure); absent further clarification or a technical correction, there is no guidance as to whether the lower-tier partnership may seek to reduce a proposed adjustment by submitting indirect partner-level information in respect of partners investing through the upper-tier partnership.
New Rules – Election for Certain Smaller Partnerships
Certain partnerships may elect alternative treatment under one of two options. Under one such election, a partnership with 100 or fewer partners may opt out of the new general audit regime by making an affirmative election for each taxable year for which the partnership seeks to opt out of the new rules. Although similar to the existing regime for partnerships with 10 or fewer partners, additional conditions will apply. Specifically, a partnership will be eligible to elect out if:
- The partnership is required to furnish 100 or fewer Schedule K-1 statements to partners; and
- Its partners consist solely of individuals, corporations (including certain foreign entities) and estates of deceased partners. Special rules apply for purposes of determining the number of partners in the case of a partner that is an S corporation.
If an eligible partnership were to make this election, certain procedural issues relating to an audit would need to be addressed directly by each individual partner. For example, the partnership would not be able to settle any audits on behalf of its partners; any settlement agreements or extensions of the statute of limitations would instead be agreed between each partner and the IRS.
Observation: Notably, the presence of a partner that is itself a partnership (or a trust) will cause a partnership to become ineligible for this smaller partnership election. Presumably, the drafters of the legislation were concerned that tiered-partnership (or trust-partnership) structures could circumvent the 100-partner limit, although this could have been addressed with a look-through rule. Commonly used partnership vehicles that will be ineligible for this election include master funds having partnership feeder funds, pooled-trading vehicles that have investing partnerships, and investment partnerships that serve as investment options for certain funds of funds.
New Rules – “Push-Out” Election
Alternatively, a separate “push-out” election, to be made by an audited partnership within 45 days of a final adjustment, will allow the partnership to issue adjusted Schedule K-1 reports to those who were partners during the year under audit; those partners would then reflect the resulting adjustment to partnership tax items in their own tax returns for the year in which the audit is concluded. This election would more fairly allocate adjustments among those who were partners during the year under audit, while avoiding any requirement for the partnership or those partners to amend prior-year Schedule K-1 statements or partner tax returns. This more streamlined approach comes at a cost, however. In general, the rate of interest on underpayments of tax is determined by increasing the federal short-term rate by three percent. Under the push-out election, the rate of interest charged on underpayments is increased by two percentage points (to equal the federal short-term rate plus five percent).
Observation: Depending upon the facts (including the size of the proposed tax adjustment and resulting tax liability, the variation in investor tax profiles, and the degree of ownership change of the audited partnership), the push-out option may be a preferred choice for partnerships not otherwise eligible to opt out of the general partnership audit regime entirely by making the election available for certain smaller partnerships. Subject to forthcoming regulatory clarifications, this option may also be preferable to the current partnership audit regime generally applicable to partnerships having more than 10 partners.
New Rules – Replacement of “Tax Matters Partner” with “Partnership Representative”
The new legislation will replace the existing “tax matters partner” designation rules with a potentially more flexible “partnership representative” concept. The partnership representative will have sole authority to act on behalf of a partnership with respect to audits and partnership reviews. A partnership and its partners will be bound by the actions taken by the partnership representative and any final decision in an audit proceeding involving the partnership. As amended, the Code requires that the partnership representative be “a partner (or other person) with a substantial presence in the United States.”2 This language raises the possibility of a partnership designating a person other than a partner to act as the partnership representative. Future regulations will address in greater detail the manner in which a partnership representative shall be designated.
Observation: The ability to designate as a partnership representative a person other than a “general partner” or “managing member” (as is currently required when designating a tax matters partner) will be a welcome development. In particular, such flexibility will alleviate the uncertainty that arises when designating tax matters partners for “check-the-box” partnerships that have no “general partner” or “managing member,” as well as the difficulties faced by partnership sponsors that, for regulatory reasons, may be unable to act as general partners or managing members. On the other hand, it is unclear how the requirement that the partnership representative have “a substantial presence in the United States” will impact partnerships that have non-U.S. general partners or managing members who currently act as tax matters partners.
New Rules – Effective Date
The new partnership audit rules generally are scheduled to apply to partnership returns filed for partnership taxable years beginning after 2017. A partnership may, however, elect to apply the new rules (other than the election out for smaller partnerships satisfying the 100-or-fewer Schedule K-1 requirement) to any partnership returns filed for partnership taxable years beginning after November 2, 2015, and before January 1, 2018. Temporary regulations, effective August 5, 2016, provide details regarding the time and manner of making this early “opt-in” election. In general, this election may be made only after the IRS first notifies a partnership in writing that a partnership return for an eligible taxable year has been selected for examination. The partnership has 30 days from the date of that notice to make the election.
Observation: As applied to an investment partnership that has a calendar year taxable year, the new rules will first take effect for the 2018 calendar year, unless the partnership elects to opt in early following receipt of an IRS notice that a partnership return for the 2016 or 2017 calendar year has been selected for examination. In the absence of regulatory guidance, a partnership would do so at its peril, as the consequences of an early opt-in election are unclear. Furthermore, for an eligible partnership having 100 or fewer investors, the smaller partnership election, which otherwise may be an attractive option when the new regime takes effect in 2018, will not be available for the 2016 and 2017 return years. An early opt-in would also deprive an otherwise eligible partnership of the current law exception for certain small partnerships having 10 or fewer partners for the 2016 and 2017 return years.
Practical Considerations for Investment Partnerships
The new partnership audit rules potentially will affect any investment partnership that files a U.S. partnership return for a return year beginning on or after January 1, 2018. Affected investment vehicles include U.S. partnerships, limited liability companies or other unincorporated U.S. entities that are treated as partnerships for U.S. federal income tax purposes. Non-U.S. fund vehicles that are treated as partnerships for U.S. federal income tax purposes (whether by default or by application of a so-called “check-the-box” election) will also be impacted if required to file U.S. partnership returns. Non-U.S. investment partnerships may trigger a U.S. partnership return filing obligation as a result of conducting (actual or imputed) business activity in the United States, or (as is more often the case) as a consequence of admitting (direct or, in some cases, indirect) U.S. investors.
Many aspects of the new rules – including the scope and impact of the smaller partnership and “push-out” elections, the requirements for designating a partnership representative, and the impact on tax-exempt, non-U.S. and other potentially “tax-favored” partners – require further IRS consideration and guidance. Acknowledging that partnerships will need to revise their agreements to comply with the law, IRS officials have publicly confirmed their intention to issue regulations before the new rules take effect in 2018.
While forthcoming regulations may indeed require further action, investment partnerships (particularly if newly formed or otherwise amending their organizational documents) may wish to consider taking some pre-emptive steps now. Organizational documents should address certain basic aspects of the new regime, such as who will designate (or be designated as) the partnership representative. Consideration should also be given to whether the partnership representative should have broad authority to make all available elections in its sole discretion. Investment partnerships may also consider “clawing back” from audit-year partners any partnership-level tax liability that results from an audit. In addition, offering documents should contain updated disclosures reflecting the new partnership audit rules. Side letter negotiations may accelerate the need for investment partnerships to consider these points.
The discussion above highlights only some of the issues confronting investment partnerships and their partners with respect to the new partnership audit rules. Although many aspects of the new rules require further clarification, what is clear is that these rules will significantly change the administration of partnership audits. Although these changes generally will not take effect until after December 31, 2017, investment partnerships should begin to consider their impact on partnership operations and offering documents.