Federal Tax Alert
The U.S. Treasury Department and the Internal Revenue Service (“IRS”) recently reissued 277 pages of proposed regulations and a preamble (REG-136118-15) regarding the new centralized partnership audit rules enacted as part of the Bipartisan Budget Act of 2015 (“BBA”), which are to be effective for tax years beginning after December 31, 2017. The proposed regulations are lengthy and complex, but (fortunately for practitioners and businesses that have been studying the proposed regulations as originally issued on January 18 and withdrawn by the IRS only two days later), the newly-reissued proposed regulations are largely identical to the original proposed regulations. The remainder of this alert summarizes the new Subchapter K entity audit rules based on all regulations issued to date, and also includes a warning that the time for action is now upon us (and by “action” we primarily mean amending current partnership and LLC operating agreements to implement the new rules).
Overview of New Rules
The BBA repealed the existing rules regarding partnership audits and replaced them with fairly radical new procedures, which are codified under Sections 6221 to 6231 of the Internal Revenue Code. Under the new rules, the IRS will audit a partnership’s tax items and the partners’ distributive shares for a particular year (the “reviewed year”), and any audit adjustments will be made at the partnership level and taken into account by the partnership in the year the audit or judicial review is completed (the “adjustment year”). If an audit results in a tax deficiency, the “imputed underpayment” presumptively will be assessed against and collected from the partnership rather than the individual partners.
Unless the partnership timely elects out of the new regime, or unless certain elections are made as described below, the adjustment year partners will therefore bear the audit assessment, including interest and possibly penalties, even if some or all are different than the partners in the reviewed year. Thus, under the new rules, partners can be on the hook for someone else’s income tax liability (fairly radical, right?!). The new audit regime raises the question whether partnerships can even be called true “pass-through” entities anymore, since IRS assessments of partnership tax underpayments will no longer automatically be “passed through” to the reviewed year partners.
Once a partnership has received notice of a proposed partnership adjustment from the IRS, it will generally have nine months to submit information to the IRS in order to have the imputed underpayment reduced. The underpayment can be modified by proof of amended returns having been filed by one or more reviewed year partners and payment of the related tax, in which case the underpayment will be reduced by the adjustments taken into account by the amended returns. The underpayment can also be reduced by proving the existence of tax-exempt partners with no liability for unrelated business taxable income, as well as proof of the existence of partners with tax rates lower than the current 39.6 percent rate, e.g. C corporations.
How to Account for Entity-Level Assessments
Assessments against a partnership will most likely have an effect on the tax bases and capital accounts of the partners, as well as the book value and basis of the partnership’s property. The proposed regulations mention these issues but reserve a place for, and request comments on, rules to address these potential adjustments, so in the meantime partnerships will have to determine, with their advisors, the best method for dealing with the issues.
Election to “Push Out”
Rather than the partnership itself paying the assessment, the new rules allow the partnership (through the partnership representative) to elect to instead have the reviewed year partners make the imputed underpayment. The partnership must make this election no later than 45 days after the IRS mails a “notice of final partnership adjustment.” If the partnership makes this election and sends required adjustment statements to reviewed year partners and the IRS, the proposed regulations confirm that the partnership is no longer liable for the imputed underpayment. It instead becomes the obligation of the reviewed year partners (based on each partner’s distributive share of any tax, interest and penalties). A downside to this “push out” election is that the interest rate on the imputed underpayment is two percentage points higher than if the partnership pays the imputed underpayment.
The proposed regulations reserve the issue whether tiered partnerships can push out adjustments beyond the first tier. The Preamble to the initial proposed regulations, published this past January, as well as subsequent public comments by various Treasury officials, indicate a concern that allowing push out adjustments through multiple tiers would create “complexities, challenges, and inefficiencies” that the new rules are intended to alleviate. The IRS has invited comments on how it might efficiently administer the audit regime in tiered partnership structures.
The Partnership Representative, or “Czar”
Another significant change under the new rules is the designation of a “partnership representative,” which replaces and entirely alters the concept of the “tax matters partner” under the current Tax Equity and Fiscal Responsibility Act (“TEFRA”) rules. The partnership representative -- who is not required to be a partner -- will have considerably more control and influence than the tax matters partner has under the current TEFRA rules. The partnership representative has exclusive authority to take actions under the new rules on behalf of the partnership that will bind each of the partners for purposes of the audit regardless of any contrary provision of state law, or the partnership agreement, or any other document or agreement. In addition, only the partnership representative may raise defenses to IRS assessments, even defenses that only relate to an individual partner (including a partner’s liability related to the partnership making a “push-out” election as described above). Thus, even if the partners negotiate contractual rights and protections in the partnership or LLC operating agreement (which we highly recommend), their recourse against any harm caused by the partnership representative will be for breach of contract or perhaps breach of fiduciary duty either under state law or under the agreement rather than renegotiating any agreement with the IRS.
Under the new rules, a partnership must designate the partnership representative for each tax year on the partnership’s timely filed return for the tax year, and a designation for one tax year is not effective for any other tax year. The designated partnership representative can be an entity, as long as it has a substantial presence in the United States, but the proposed regulations add an additional layer of complexity and require that the partnership then must also designate an individual who meets the substantial presence test to act on behalf of the partnership representative entity. Generally, a partnership representative designation may not be changed until the IRS issues a notice of administrative proceeding to the partnership, except when the partnership files an administrative adjustment request for a valid purpose other than changing the partnership representative. The proposed regulations, however, allow the partnership to revoke the partnership representative designation or the “designated individual” appointment and designate a successor in certain circumstances.
As mentioned, the proposed regulations confirm that “eligible” partnerships may elect out of the new rules on an annual basis, with “eligible” meaning that the following two conditions must exist: (1) the partnership must not be required to issue more than 100 Schedules K-1; and (2) all partners must be “eligible partners,” which are defined narrowly as individuals, C corporations, foreign entities that would be treated as C corporations if domestic, S corporations, and estates of deceased partners. The proposed regulations also confirm that partnerships with even one trust (including a grantor trust), or partnership, or disregarded entity such as a single-member LLC as a partner are not eligible to opt-out of the new rules. Thus, for example, a joint venture consisting of two single-member LLCs, each of which is owned by an individual or entity that would itself qualify as an eligible partner, will be subject to the full force of the new rules and not eligible to elect out. The proposed regulations further confirm that, in counting heads, each shareholder of an S corporation partner is counted as a partner for this purpose. The proposed regulations also clarify that a partnership that has elected out of the new rules is still subject to them in the context of determining its liabilities as a partner in a partnership that has not or could not elect out.
If a partnership validly elects out of the new rules for a particular tax year, the partnership will simply be subject to the general rules for the assessment and collection of tax deficiencies, so any adjustments to partnership taxable items will flow through to the partners (similar to the current TEFRA rules, which are repealed in their entirety).
State and Local Tax Considerations
While Arizona hurriedly passed legislation that partially conforms to the new rules, few other states have a mechanism for allowing them to audit or to collect income tax directly from an entity classified as a partnership, other than perhaps through a composite tax return or withholding mechanism applicable only to certain nonresident partners. Both the Multistate Tax Commission and a working group consisting of the Council On State Taxation, the Tax Executives Institute, the American Institute of CPAs, the ABA Tax Section SALT Committee, and the Institute for Professionals in Taxation (IPT) have a current project devoted to addressing state conformity issues and developing model provisions. Our own Bruce Ely and Will Thistle co-chair the ABA SALT Committee Task Force. Their group has already issued a draft model statute for consideration by the states.
Accounting for New Rules in Acquisition Agreements
In addition to the issues that need to be addressed in both current and future partnership agreements and LLC operating agreements (discussed below), the new rules will need to be addressed in partnership merger and acquisition agreements. Sellers of partnership interests will want certain reserved rights with regard to any potential reviewed years that could impact their personal obligations to the partnership, other partners, and/or the IRS. Conversely, buyers should consider any tax liabilities that could be imposed under the new rules on the partnership or on the buyer itself, whether arising from the new rules or the partnership or LLC operating agreement.
Taking Action Now
All entities classified as partnerships for federal income tax purposes should amend their partnership or LLC operating agreements to account for the new rules by the end of this year, if they have not already done so, taking into consideration both the difficulties that can be encountered with entity-level taxation as well as the very real likelihood of increased IRS and state audit activity under the new regime. Among the items that should be addressed are the following:
the designation and removal of the partnership representative
the designation and removal of the individual that must be appointed if the partnership representative is an entity
the requirements for the partnership representative and partners to obtain and provide information that may reduce the partnership’s liability for the imputed underpayment
partner consent required, if any, for the making of elections or settlements by the partnership representative, including the election out and the push-out election
the potential for filing amended returns by those who were partners in the reviewed year(s)
terms and conditions for amending the partnership or LLC operating agreement to deal with changes or updates to the new rules
restrictions on transfers of partnership interests to entities that are ineligible partners
partners’ notice and participation rights in connection with IRS or state audits
appropriate indemnifications for the partnership representative
how to ensure that the appropriate partners and former partners bear the actual costs of imputed underpayments, including cooperation requirements for former partners