On Nov. 2, 2015, the Bipartisan Budget Act of 2015 was enacted, fundamentally changing the manner in which the U.S. Internal Revenue Service (“IRS”) conducts audits of entities that are taxed as partnerships for U.S. tax purposes and collects resulting tax liabilities. Generally, the new partnership tax audit rules provide that, absent an election, a partnership, and not its partners, will be required to pay any federal tax deficiency relating to a partnership audit adjustment. The new partnership tax audit rules will be effective for taxable years beginning after Dec. 31, 2017, and it may be advisable to make certain changes to your fund organizational and disclosure documents in anticipation of these new rules.
Under the existing partnership tax audit rules, in the event that an item of partnership income or loss is adjusted in an IRS audit, a fund that is treated as a partnership for U.S. tax purposes issues amended Schedules K-1 to the investors that were partners of the fund during the year under audit (“Audit Year”). Such investors are then required to amend their own tax returns for the Audit Year and pay any tax shortfall resulting from the adjustment (plus interest and penalties, as applicable).
Under the new partnership tax audit rules, in the event that an item of partnership income or loss is adjusted in an IRS audit, a fund that is treated as a partnership for U.S. tax purposes will be liable for a tax (plus interest and penalties, as applicable) equal to the amount of the adjustment multiplied by the highest marginal tax rate (“Audit Tax”). The fund can then either pay the Audit Tax (subject to reduction, as discussed below) or make an election under Section 6226 of the U.S. Internal Revenue Code of 1986, as amended (“Section 6226 Election”), to push the audit adjustment out to the investors. If the fund decides to pay the Audit Tax, the fund may be able to reduce the Audit Tax (i) by demonstrating to the IRS that a portion of its current investors either would be exempt from tax or taxed at lower rates, or (ii) by having the applicable investors voluntarily agree to amend their tax returns to include their share of the audit adjustment. If the fund decides to make a Section 6226 Election, the audit adjustment would be “pushed out” to investors that were partners of the fund during the Audit Year. Such investors would be liable for the tax (plus interest at a rate 2 percent higher than the regular underpayment interest rate and penalties) directly at their level, taking into account their other tax attributes. However, there is still uncertainty regarding whether an audit adjustment can be pushed out through partnership tiers (e.g., from a master fund to the feeder fund and then to the feeder fund’s investors). As a result, it may not be tax advantageous for particular funds to make a Section 6226 Election.