With December 31, 2017 approaching, many advisors to foundations and charities are focused on the various proposals coming out of Washington on tax reform. However, advisors to tax-exempt organizations cannot lose sight of the potential impact that the new partnership audit rules will have. Specifically, without adequate review of all of the new issues that must be considered in light of these new rules, a tax-exempt entity that makes an investment in a limited partnership or limited liability company could find themselves paying for tax costs on income tax that should be tax-exempt.
Overview of the New Partnership Audit Rules.
Under the Act, any adjustments made to a partnership’s items of income, gain, loss, deduction, credit and partners’ allocable shares thereof will be made at the partnership level. Any imputed underpayment will be assessed and collected at the partnership level, or the partnership may elect to “push out” adjustments to the partners who were partners during the year subject to the audit. For more information on the general impact of the Act’s provisions on investors, see New Partnership Audit Rules Require Attention of Investors.
Status of the Release of Final Guidance on the New Partnership Audit Rules.
The new partnership rules take effect on January 1, 2018. In January 2017, the IRS issued proposed regulations which set forth detailed rules on how the new partnership audit rules were to be applied. These proposed regulations were not officially issued in January and their release was stopped under an executive order issued on January 20, 2017. However, the proposed regulations were re-released on June 13, 2017 (REG-136118-15) in substantially similar form as the version that was unofficially released in January 2017.
On September 18, 2017, the IRS held a hearing on the proposed regulations to implement the centralized partnership audit regime enacted as part of the Bipartisan Budget Act of 2015. Despite a recommendation by the American Institute of CPAs to delay the implementation of the new partnership audit rules by one year, it appears that these new rules are on track to be applicable to tax returns filed for partnership tax years beginning after December 31, 2017.
Issues to be Considered once the New Partnership Audit Rules Become Effective.
Several issues relevant to tax-exempt investors relating to the new partnership audit regime have emerged from the proposed rules, which can be addressed in the partnership agreement following negotiation with the fund’s manager:
- If the partnership does not utilize the “push-out election” under Code Section 6226 to pass through adjustments to partners, the “partnership representative” (usually the general partner) is not obligated to take the tax status of partners into account when allocating any imputed underpayment. This means that if protective provisions are not included in the partnership agreement or a side letter, a tax-exempt partner may be required to bear the economic burden of a tax liability on income that would otherwise be tax-exempt.
- Related to the above point, the proposed regulations do not set forth a mechanism that a partnership must use to allocate the tax costs resulting from the audit among the partners if no push-out election is made. As a result, if a partnership agreement fails to adequately provide that tax costs related to tax-exempt income cannot be allocated to tax-exempt partners, a tax-exempt partner could, in effect, be required to bear the economic burden of tax costs that it would not have otherwise been subject to due to its status as tax-exempt.
- Furthermore, unless the partnership agreement provides that former partners remain liable for tax obligations, the partners in the year of the audit may bear the burden of tax liability that should be borne by former partners who were partners in the year subject to the audit.
- The proposed regulations provide that the partnership representative must raise defenses to penalties, additions to tax, or additional amounts, including defenses that relate to any partner prior to the conclusion of the audit. Any defense that is not raised by the partnership before a final determination is waived and will not be considered if raised by any other person, including a partner that receives a section 6226 statement as a result of the partnership making a push-out election.
This means that if the partnership representative does not advise the IRS of the tax status of partners at that time, tax-exempt partners will not have the ability to reduce or eliminate their portion of any imputed underpayment and may be allocated a portion of an imputed underpayment by the partnership (unless the partnership agreement or a side letter contains protective provisions for tax-exempt partners) or may be required to include its share of the imputed underpayment on its tax return (if the partnership makes the “push-out” election under section 6226).
Many funds have adopted "boilerplate" language in the partnership agreement to give the general partner (or its designee) broad powers under the new partnership audit rules. In many cases, specific language must be negotiated into side letters to protect the tax-exempt partner from being put in a position to fund tax liabilities and costs related to partnership income that would otherwise be tax-exempt to the partner. In addition, specific language should be negotiated that obligates the partnership representative to advise the IRS of the tax status of partners at the time of an audit. In the absence of this obligation, the tax-exempt partners could be precluded in some circumstances from reducing or eliminating their portion of any imputed underpayment and may be allocated a portion of an imputed underpayment by the partnership.
Although no one has experienced an audit under the new partnership audit regime, it is advisable for tax-exempt investors to ensure that their interests are protected in the partnership agreement or in a side letter in order to minimize the chance that they will bear the economic burden of a tax liability to which they should not be subject.