The Bipartisan Budget Act of 2015 (the Act) repealed and replaced the rules that apply to partnership audits and the collection of taxes owed as a result of an audit. The new rules are intended to enable the Internal Revenue Service (IRS) to more easily audit and assess taxes against partnerships. This article provides a brief overview of these new rules and a discussion of the impact that they may have on investors in partnerships.
General Impact of the Act’s Provisions
Under the current partnership audit provisions, certain audits must be conducted at the partnership level while others are conducted at the partner level. In either case, upon a determination of a tax deficiency, the IRS must collect the deficient taxes, penalties, and interest directly from the partners. The Act, by default, can shift the obligation to pay these taxes to the partnership.
The Act grants the IRS the authority to assess any tax deficiency arising from a partnership-level adjustment using the maximum statutory income tax rate. The Act also allows the IRS to, in some circumstances, collect the tax deficiency from the partnership. In addition, under the Act, the tax deficiency is collected in the year that such audit or any judicial review is completed (together with any related penalties and interest), as if the partnership had been originally liable for the tax in that year rather than in the prior tax year that was audited.
There are a number of elections that a partnership can make that will affect how the new partnership audit provisions are applied. For example, the partnership can elect to require partners to file amended returns and pay the resulting tax, interest, and penalties, rather than have the tax liability assessed and collected from the partnership. Similarly, under Treasury Regulations to be issued at some time in the future, partnerships may also have an opportunity to submit information to the IRS showing that the underpayment should be reduced due to partner-specific tax characteristics such as the tax-exempt status of a partner.
Matters for Consideration
- The Opt-Out Election The Act’s provisions provide an “opt-out” election for certain small partnerships, with the result that adjustments to the items of a partnership that “opts-out” can be made only at the partner level. This “opt-out” election may only be made by a partnership with 100 or fewer partners, each of which is an individual, a C corporation, an S corporation, or an estate of a deceased partner. This opt-out may not be available for most large private equity funds, particularly those with tax-exempt partners.
- The Designated “Partnership Representative” The Act eliminates the concept of a “tax matters partner” and introduces the concept of a designated “partnership representative.” The powers of the “partnership representative” under the new rules are expanded from those of the “tax matters partner.” In particular, the partnership representative, who is not required to be a partner, will have sole authority to act on behalf of the partnership in an audit proceeding. The IRS no longer will be required to notify partners of partnership audit proceedings or adjustments, and partners will be bound by determinations made at the partnership level. It appears that partners neither will have rights to participate in partnership audits or related judicial proceedings, nor standing to bring a judicial action if the partnership representative does not challenge an assessment.
- Reimbursement by Partners for Taxes Paid by the Partnership Under the Act, the IRS has the authority to collect unpaid taxes resulting from an audit (including penalties and interest) from a partnership. Given that an audit typically occurs several years after the filing of a return, a partnership may be required to pay the liability of former partners (if any) that were partners for the reviewed year. The Act does, however, provide a means by which a partnership may elect to shift the burden of underpayments to the partners who were partners during the taxable year to which the underpayments relate.
Effective Date of Revised Partnership Tax Provisions
In general, the new tax rules will apply to partnership returns filed beginning after December 31, 2017.
General partners of partnerships in formation are including provisions in their partnership agreements that address the Act. Similarly, existing partnerships are amending their partnership agreements to incorporate similar provisions. The early versions of these agreement provisions appear to significantly vary in approach; however, many of them are not favorable to tax-exempt investors. They may include indemnification provisions or other reimbursement language that would require a tax-exempt investor to bear taxes, penalties and interest that would exceed the taxes that such tax-exempt investor would otherwise bear on unrelated business taxable income. In other words, the language could effectively require such tax-exempt investors to bear taxes that today would be borne by taxable investors. Therefore, a tax-exempt investor in a partnership should consider the following:
- Review its partnership agreements and partnership agreement amendments closely to determine how the relevant partnership is addressing the Act’s provisions and whether the language attempts to attribute the tax liability only to those investors who would have originally borne the tax, and obligates the general partner to attempt to reduce the tax liability based on partner-specific characteristics.
- If the language addressing the Act is unfavorable to tax-exempt investors, consider discussion and negotiation with the partnership, and perhaps a side letter addressing the issue, so that the investor does not unfairly bear more than its portion of the tax adjustment.
- Be aware of the constitution of the partnership since the general partner may not be as sensitive to the positions of tax-exempt investors if they represent a minority of the investor base of the partnership.
- Give consideration to including in a side letter the notices that the investor desires to receive from the partnership representative with respect to audits and tax adjustments.
All investors, including those that are taxable, should give consideration to the following:
- Under the Act, the tax matters partner role is replaced by the “partnership representative” who can bind the partners with respect to proposed tax adjustments without their knowledge or consent. The partnership agreement should be reviewed to determine whether the vote or consent of the investors is required for the partnership representative to bind the partners with respect to an issue under audit by the IRS.
- The Act allows the partnership to make an election that would replace the partnership’s obligation to pay the tax deficiency and place it instead on the partners by requiring that the partners file amended returns to reflect the adjustment required under the audit. However, if this election is made and the partners are required to amend their returns, the interest rate imposed on the underpayment amount will be increased by two percentage points. The partnership agreement should be reviewed to determine whether the partnership is permitted to make this election.
- Under the Act, if the partnership is required to pay the tax liability, the Act provides no specific mechanism for the partnership to recover this cost from the investors. The partnership agreement should be reviewed to confirm whether this allocation is subjective or based on some measurable standard.