On November 2, 2015, President Obama signed the Budget Act of 2015 (the “2015 Budget Act”), which makes significant amendments to the procedural rules governing federal income tax audits and judicial proceedings that apply to partnerships and other entities (such as limited liability companies or statutory trusts) classified as partnerships for federal income tax purposes.
The new rules represent a radical change in the federal income tax treatment of entities classified as partnerships for federal income tax purposes. Under fundamental partnership tax principles, an entity classified as a partnership for federal income tax purposes is a flow-through entity and thus is not subject to federal income tax. Rather, each partner is individually taxed on its allocable share of the partnership’s income, gain, loss, deduction and credit arising in the years during which the partner is a partner in the partnership. Consistent with this approach, federal income taxes arising from adjustments to partnership items following an audit of a partnership historically have been assessed against the partners who were partners during the years under audit.
The procedural rules enacted in the 2015 Budget Act take a dramatically different approach. In general, the new rules impose liability for federal income taxes directly on the partnership, irrespective of any changes in the ownership of the partnership that might have occurred between the taxable year in which the partnership items arose and the taxable year in which the partnership items are finally adjusted. These rules, which generally become effective in 2018, have the potential to significantly alter the economic arrangements of the partners relating to taxes and to greatly increase the tax risks of acquiring interests in existing partnerships. In particular, the new rules transfer the economic risk of adjustments to partnership items from the partners who were allocated such items to the partners who own the partnership at the time the adjustments are made.
Current Law—TEFRA, Small Partnership and ELP Rules
For federal income tax purposes, most partnership audits and judicial proceedings are governed by the so-called TEFRA (Tax Equity and Fiscal Responsibility Act of 1982) rules. Under these rules, partnership audits and judicial proceedings are conducted at the partnership level. At the conclusion of the TEFRA proceedings, any adjustments to partnership items for the taxable year under audit are taken into account at the partner level, and the partners are individually assessed for any federal income taxes resulting from their respective shares of the adjustments. Thus, under the TEFRA rules, any federal income tax liability resulting from adjustments to partnership items is assessed at the partner level, not at the partnership level. The TEFRA rules generally provide for a partner, i.e., the “tax matters partner,” to have the authority to conduct the audit and any proceedings at the partnership level on behalf of the partnership, but generally require that partners be notified of the proceedings and allow individual partners to contest adjustments agreed to by the tax matters partner.
The TEFRA rules include a “small partnership exception.” Under this exception, the TEFRA rules do not apply to a partnership with 10 or fewer partners, all of whom are qualifying partners (which do not include partners that are themselves partnerships), unless the partnership makes an affirmative election to apply the TEFRA rules. For qualifying small partnerships that do not elect to apply the TEFRA rules, audits and judicial proceedings are conducted, and any resulting assessments are made, at the partner level under the general rules that apply to individual taxpayers.
Partnerships with more than 100 partners may elect to be subject to special procedural rules that apply to electing large partnerships. In contrast to the TEFRA rules, under the electing large partnership (“ELP”) rules, partnership item adjustments are applied to the partners for the taxable year in which the adjustments are finally determined, rather than the taxable year in which the partnership items arose. Accordingly the current-year partners’ share of current-year partnership items are adjusted to reflect adjustments to prior-year partnership items.
New Rules Under the 2015 Budget Act
Under the 2015 Budget Act, the current TEFRA and ELP rules will be repealed, and the rules governing federal income tax audits and judicial proceedings involving partnerships will be streamlined into a single set of rules that apply at the partnership level.
Under the new rules, partnership proceedings will continue to be conducted at the partnership level similar to the current TEFRA rules. However, the new rules eliminate the familiar tax matters partner in favor of a new “partnership representative” who has absolute authority to bind the partnership on tax matters. Further, the new rules eliminate the rights of partners to receive notice of any tax proceedings or to separately contest adjustments agreed to by the tax matters partner. More significantly, the new rules provide that adjustments to the partnership’s income, gain, loss, deduction or credit for such year (the “reviewed year”) are taken into account by the partnership (not the partners) in the year that the audit or any judicial review is completed (the “adjustment year”). Any tax liability resulting from the adjustments (including any penalties attributable to such adjustments) is imposed on the partnership in the adjustment year as an “imputed underpayment.” This is a significant departure from the historic treatment of a partnership as a pass-through entity that is not subject to federal income tax.
In general, the amount of the imputed underpayment is determined by netting all adjustments to the partnership’s income, gain, loss or deduction for the reviewed year and multiplying the net amount of the adjustments by the highest rate of tax imposed on an individual or corporation for the reviewed year. Adjustment of allocations between partners generally will not be netted under the new rules, but rather will only take into account the increased allocations of income or decreased allocations of deductions to any particular partners. As a result, it is possible for a partnership to owe tax on an imputed underpayment due solely to an improper allocation of items of income or deduction among the partners. Under procedures to be established by the Treasury Department, the amount of the imputed underpayment may be reduced on account of (i) amended returns and related tax payments made by partners opting to file amended returns for the reviewed year, (ii) the tax rates applicable to specific types of partners (e.g., individuals, corporations, tax-exempt organizations), and (iii) the type of income subject to the adjustment (e.g., ordinary income, qualified dividends and capital gains).
As an alternative to taking the adjustment into account at the partnership level, a partnership may elect within 45 days of receiving an IRS final notice of partnership adjustment to issue statements to the reviewed-year partners setting forth their respective shares of any adjustment to the partnership’s income, gain, loss, deduction or credit. In that case, the reviewed-year partners will be required to take the adjustment into account on their individual returns in the year in which the adjustment statements are issued. If the partnership elects this alternative procedure, the new rules do not appear to provide the reviewed-year partners the ability to have a judicial review of the resulting adjustment.
Similar to the current TEFRA rule excluding small partnerships, in any taxable year a partnership with 100 or fewer partners, all of whom are qualifying partners, will be permitted to elect out of the new rules for such year (the “small-partnership opt-out election”). For qualifying partnerships that make the small-partnership opt-out election for a taxable year, audits and judicial proceedings for such year will be conducted, and any resulting assessments will be made, at the partner level under the general rules that apply to individual taxpayers. For purposes of the small-partnership opt-out election, qualifying partners do not include other partnerships. As a result, many partnerships, for example, master funds in a master-feeder structure, will not be permitted to make the small-partnership opt-out election.
A partnership will also have the option of initiating an adjustment for a reviewed year, such as when the partnership believes an additional payment is due or an overpayment was made, with the adjustment taken into account in the adjustment year. The partnership generally will be permitted to take the adjustment into account at the partnership level or issue adjusted information returns to each reviewed-year partner.
Effective Dates of New Rules
The new rules are effective for partnership taxable years beginning after December 31, 2017. However, a partnership may elect to apply the rules (other than the small-partnership opt-out election rule) for taxable years beginning after November 2, 2015, and before January 1, 2018.
For parties entering into new partnership relationships, the impact of the new rules on the relative economic and management rights and obligations of the parties should be considered in drafting the underlying partnership documents. For example, parties may want to consider whether the partnership should be obligated to make (or should be prohibited from making) the small-partnership opt-out election if available. In addition, parties may want to consider adding provisions that obligate a partner to file amended tax returns and pay any resulting tax resulting from any adjustment or to indemnify the partnership for a failure to do so. Additional indemnities may be necessary for partnerships that expect changes in the partners or their economic shares over time. Parties may also want to consider whether it is appropriate to limit the power of the partnership representative to bind the partnership without notice to and consent of the partners. These are just some of the many issues that must be considered before entering into a new partnership relationship in light of the new partnership audit rules.
Most existing partnership agreements were drafted with the TEFRA rules in mind and will not have provisions in place that reflect the economic and administrative consequences of the new rules. As a result, existing partnerships and their partners will also need to consider the extent to which the new rules will necessitate amendments to their partnership agreements to preserve their existing arrangements.
The new rules significantly increase the tax risks to persons acquiring interests in existing partnerships, whether such interests are purchased directly from the partnership or from other partners. Prospective purchasers of partnership interests will need to consider a partnership’s potential liabilities for “imputed underpayments” arising from prior year adjustments and will need to consider whether indemnity and/or escrow arrangements are appropriate to account for such potential liabilities.