With the recent re-proposal of the Treasury Regulations relating to the new partnership audit rules, hopes for a deferral of the effective date of the new rules have waned. The new rules, which were enacted as part of the Bipartisan Budget Act of 2015, will become effective for tax years beginning after December 31, 2017, and make significant changes to the current rules.
Under the new rules, audits with respect to items of income, gain, loss, deduction and credit from a partnership are generally conducted at the partnership level, and the partnership (not any of the partners) is liable for any deficiency based on an assumed tax rate. As a result, the partners in the year in which the adjustment is made (called the “adjustment year”) bear the cost, rather than the individuals who were partners in the year that was audited (called the “reviewed year”).
There are two general methods under the statute to put the burden back on the reviewed year partners. First, a partnership that has 100 or fewer partners (taking into account certain look-through rules), each of which is an individual, a C corporation (including a foreign entity that would be a C corporation if it were domestic), an S corporation or an estate of a decedent, may elect out of the new rules. Partnerships and trusts are not qualified partners for this purpose. As a practical matter, this election out will not be available to private equity or hedge funds, which typically have partnership members. Family partnerships often have trusts as members and frequently involve multiple partnership tiers so they cannot elect out either. Entities that are disregarded under the income tax law are not eligible entities. This would include grantor trusts, including revocable living trusts, and single member limited liability companies. For other partnerships, it raises questions for clients as to whether they want to prohibit nonqualified partners and disqualifying transfers so as to come within this exception, and what to do if they already have such partners.
If the partnership does not (or cannot) elect out, it may still elect to require the deficiency based on the partnership level adjustments to be paid by the reviewed year partners. In such case, however, the interest rate charged by the IRS will generally be increased by 200 basis points.
In the audit, the partnership is represented by a partnership representative who may or may not be a partner. All partners are bound by the partnership level adjustment. Net downward adjustments will not result in refunds but will reduce the partnership’s income otherwise allocated to the partners in the adjustment year. Special rules apply to misallocations between partners.
Partnership agreements, including limited liability company agreements and operating agreements for LLCs that are treated as partnerships for federal income tax purposes, should be amended to take into account the new rules if they do not already contain such provisions. Agreements for newly formed partnerships and limited liability companies should spell out how the new rules will be applied. In addition, partners entering existing partnerships need to assure themselves that provisions are in place that will prevent them from becoming responsible for the payment of taxes that relate to tax years before they became partners. If you have partnership or limited liability company agreements, please contact us so that we can review them to determine if new or revised provisions should be added based on these new rules.