Last month, the Internal Revenue Service (IRS) re-released proposed regulations (the “Proposed Regulations”) implementing the centralized partnership audit regime that was enacted on November 2, 2015 as part of the Bipartisan Budget Reduction Act of 2015 (the “BBA”). This audit regime would radically revise the rules regarding audits of LLCs and other entities treated as partnerships for U.S. federal income tax purposes ("partnerships"). The Proposed Regulations, which run 270 pages, generally would be effective for partnership tax years beginning after December 31, 2017. Accordingly, partnerships are strongly advised to consider making appropriate amendments to their partnership agreements prior to the end of the year.
The Proposed Regulations are essentially identical to the earlier set of proposed regulations released by the IRS in January of 2017. Those earlier proposed regulations were withdrawn almost immediately as a result of President Trump’s suspending the issuance of new regulations by federal agencies. Therefore, the bulk of the Proposed Regulations can be expected to be present in the final version.
Overview of the Existing Rules on Partnership Audits
Under current rules, partnership audits generally are conducted through a unified procedure at the partnership level under the so-called Tax Equity and Fiscal Responsibility Act Audit Rules (“TEFRA"). Certain partnerships with 10 or fewer direct partners are automatically exempt from TEFRA. In addition, certain large partnerships can elect to be audited under a separate set of “electing large partnership” rules.
Under TEFRA, the IRS may generally make adjustments to “partnership items” at the partnership level in one proceeding. Once the adjustments are made, the IRS makes corresponding adjustments to each partner's return. Any taxes, penalties, and interest are assessed and collected from the partners.
The Centralized Partnership Audit Regime
Repeal of Current Partnership/LLC Audit Rules
The BBA repealed the TEFRA Audit Rules and the electing large partnership rules for partnership tax years beginning after December 31, 2017. The BBA also allowed partnerships the option of applying the new rules for tax years beginning after November 2, 2015 and before January 1, 2018.
The Proposed Regulations are extensive and address many issues not dealt with in the BBA. A public hearing on the Proposed Regulations has been scheduled for September 18, 2017, and the Proposed Regulations are expected to be finalized quickly after that hearing.
General Rule – Taxes Resulting from Audits and Tax Proceedings Must Be Paid by the Partnership/LLC
For tax years beginning after December 31, 2017, all partnerships, including those with 10 or fewer direct partners, will be subject to the centralized partnership audit regime unless the partnership is eligible to elect out and makes a timely election to elect out. The option to elect out is discussed below.
Under the centralized partnership audit regime, all assessments, including penalty assessments, are made at the partnership level in a unified proceeding. The partnership is responsible for the payment of any taxes resulting from any “imputed underpayment”1 resulting from such tax proceeding at the top marginal rate under Section 1 and Section 11 of the Code (currently 35% and 39.6%). As a result, the burden of such taxes fall on persons who are partners in the year the taxes and penalties are finally determined (the “Adjustment Year”), rather than the persons who were partners in the year under audit (the “Reviewed Year”). Because tax is imposed at the top marginal rate and tax attributes of partners are not taken into account, the tax liability of the partnership determined in this manner will often exceed the tax liability that would have been imposed on the partners directly.
Partnership Agreements need to address how liability for the taxes and penalties imposed on the partnership will be allocated between persons who are partners in the Adjustment Year and persons who were partners in the Reviewed Year. In the absence of such provisions, the burden will fall on the Adjustment Year partners. This burden can be shifted by providing that the Reviewed Year partners are obligated to indemnify the Adjustment Year partners or to make contributions to the partnership to pay the taxes and penalties. However, such provisions would need to impose such obligations on Reviewed Year partners and also must provide that these obligations survive the withdrawal by a partner from the partnership and the dissolution of the partnership. Another option, discussed below, is for the partnership to make a “push out” election. In either case, the obligations of current partners and former partners should be clearly spelled out.
There is no one provision that will be suitable for all partnerships. Rather the partners will have to negotiate terms regarding their respective rights and responsibilities, and different partners will often have conflicting interests. This is one reason that partnerships should amend their partnership agreements prior to the end of the year before the changes made by the centralized partnership audit regime go into effect.
The Role of the Partnership Representative
The partnership is represented in all federal income tax proceedings by its “partnership representative.” The partnership representative is intended to replace the role of the “tax matters partner” under TEFRA, but has much broader authority to make all decisions and bind the partnership and other partners in audits and other tax proceedings.
Each partnership must annually designate a person to act as its partnership representative for a taxable year on its timely filed tax return (including extensions) for that year. The partnership representative does not need to be a partner, but does have to have a substantial presence in the U.S. Once a partnership representative has been designated for a tax year, that person will remain as the partnership representative for that year until he or she is either removed or resigns. The Proposed Regulations contain detailed rules on designating partnership representation and how, and when, the partnership representative may be terminated or resign,and a new partnership representative may be appointed for a tax year.
If the partnership representative is an entity, the Proposed Regulations require the partnership to appoint a “designated individual” as the sole individual to act on behalf of the partnership representative. The designated individual must also have a substantial presence in the U.S.
The partnership representative has the sole authority to represent the partnership in a federal income tax audit or tax proceeding. The partnership and all partners are bound by any actions or decisions of the partnership representative.In addition, only the partnership representative may raise defenses to penalties, including defenses that may be available to some partners but not others. Any defense not raised by the partnership representative is waived, and defenses will not be considered if raised by a person other than the partnership representative. No partner other than the partnership representative has a right to notice of any audit, proceeding or partnership adjustment, and no partner other than the partnership representative may participate in an audit or tax proceeding without the consent of the IRS.
In addition, the partnership representative’s authority to bind the partnership and the other partners cannot be limited by state law, the partnership agreement, or any other document or agreement. Partnership agreements may require that the partnership representative must provide partners with copies of notices, keep them informed of the progress of any audit or tax proceeding, or obtain consent before agreeing to an extension of the statute of limitations, a settlement, or making an election, but such provisions do not limit the power of the partnership representative to bind the partnership and its partners in dealing with the IRS. Thus, partners will have to rely to a much greater degree on the partnership representative to protect their interests in an audit or tax proceeding. They will also want to spell out carefully the obligations of the partnership representative under the partnership agreement.
The additional authority conferred on the partnership representative under the centralized partnership audit regime, and the limitations on the powers of other partners, carries with it the risk that the partnership representative may be sued by partners that are unhappy with the outcome of an audit or the actions of the partnership representative. There have been reports that some partnerships are having difficulty finding a person willing to act as the partnership representative because of such concerns. Where persons are willing to take on these responsibilities, the partnership representative will often seek provisions that limit its fiduciary duties to the other parties, circumstances under which it can be sued (e.g., reckless disregard), and provide for strong indemnity protection.
The BBA requires partners to report each item of income, gain, loss, deduction, or credit attributable to a partnership in a manner that is consistent with the treatment of such item on the partnership return. If the partner fails to comply with this requirement, any underpayment of tax resulting from that failure may be assessed and collected as if such underpayment were on account of a mathematical or clerical error appearing on the partner's return. As a result, the IRS may collect such amount without relying on the deficiency procedures. To avoid this treatment, the partner must notify the IRS of the inconsistent treatment on the partner's return.
Election out of Centralized Partnership Audit Regime
In general, all partnerships (domestic and foreign) required to file a U.S. federal income tax return are subject to the centralized partnership audit rules for tax years beginning after December 31, 2017. The exceptions under TEFRA for small partnerships and electing large partnerships are repealed. As a result, a significant number of partnerships that were exempt from the TEFRA Audit Rules will be subject to the new centralized partnership audit regime. The IRS has also indicated that it intends to increase dramatically the number of audits of partnerships.
Certain “eligible partnerships” can elect out of the centralized partnership audit regime (an “Election Out”), but the number of partnerships eligible to make the election is limited. To make an Election Out, a partnership must satisfy two requirements. First, the partnership must have 100 or fewer partners. The determination of the number of partners a partnership has is based on the number of K-1s it is required to issue and is broadly applied. If a partnership has an S corporation as a partner, the number of K-1s issued by the S corporation are included in this calculation. A husband and wife are treated as two partners for this purpose. Second, the partnership must only have “eligible partners.” Eligible partners are individuals, C corporations (including organizations exempt under Section 501(a) that are treated as corporations for federal tax purposes), eligible foreign entities (foreign entities that are classified as corporations under the check-the-box rules), S corporations, and estates of deceased partners. The Proposed Regulations provide that “eligible partners” do not do not include partnerships, trusts, foreign entities that are not “eligible foreign entities”, disregarded entities, nominees, other similar persons that hold an interest on behalf of another person, or estates that are not estates of a deceased partner. This will significantly limit the number of “eligible partnerships” that can make an Election Out.
The election must be made on the partnership’s timely filed return (including extensions) for the year to which the election relates. To make the election, the partnership must disclose to the IRS the names, TINs, and federal tax classifications of all partners of the partnership and, if there is an S corporation partner, the names, TINs, and federal tax classifications of all persons to whom an S corporation partner is required to furnish statements during the S corporation's taxable year ending with or within the partnership's taxable year at issue, as well as any other information regarding those partners (and shareholders) as required by the IRS in forms and instructions. In addition, the partnership must notify each of its partners that the partnership made the election within 30 days of making the election. The election may be revoked only with the consent of the IRS.
If an Election Out is made, partnership audits will be conducted under the pre-TEFRA rules. Under those rules, all audits and assessments will be made at the partner level, rather than in a unified audit proceeding at the partnership level. The burden of defending such audits, and the burden of any tax liabilities and penalties, will fall on the persons who are partners during the Reviewed Year. Because conducting audits in this manner is extremely burdensome for the IRS, the Proposed Regulations attempt to limit Elections Out.
Partnership agreements should carefully address the circumstances in which an Election Out will be made. Some partnerships may wish to provide that the partnership must elect out if an Election Out is available. Others will want to include provisions indicating how the decision to make an Election Out will be made. Partnerships that want to assure that they will be able to make an Election Out may wish to consider revising the transfer provisions of their partnership agreements to prohibit transfers to any person who is not an eligible partner.
Other stakeholders also have an interest in whether an Election Out is made. Because the Election Out shifts the burden of taxes and penalties to persons who were partners in the Reviewed Year, persons who buy or sell a partnership interest may want assurances as to whether Election Out will be made or indemnity for taxes depending on whether the Election Out is made. Similar considerations will be important in M&A transactions involving partnerships.
Lenders may also have to take a renewed interest in the possibility that partnerships may be liable for income taxes. One of the panels at the ABA Tax Section Meeting in May of 2017 reported that some lenders have begun including new covenants in connection with loans to partnerships requiring the partnership to (i) make an Election Out if it is eligible to do so, (ii) provide copies of all correspondence from the IRS to the lender; and (iii) fully reserve for any potential income tax liabilities if an audit is commenced. Whether such covenants will become common remains to be seen.
Modification Requests by Partnership/LLC
As explained above, under the centralized partnership audit regime, the partnership must pay tax on any imputed underpayment. Because of the manner in which the imputed underpayment is calculated, the partnership’s tax liability may be overstated compared to what the partners would have paid if the partnership had property reported originally.
To reach the correct amount of tax, the IRS allows the partnership to request modification to adjust the imputed underpayment amount down to the correct amount of tax. In general, the request for modification must be made within 270 days after the notice of proposed partnership adjustment is mailed by the IRS. A partnership requesting modification must substantiate the facts supporting a request for modification to the satisfaction of the IRS. The particular documents and other information that may be required are based on the type of modification requested.
As explained above, under the centralized partnership audit regime, the partnership generally must pay tax on any imputed underpayment. The partnership’s tax liability may be overstated, and absent an indemnity obligation from the partners in the Reviewed Year in favor of the partners in the Adjustment Year, the burden of such taxes will fall on persons who are partners in the Adjustment Year.
To address this issue, the partnership may elect to have its Reviewed Year partners take into account the adjustments made by the IRS and pay any tax due as a result of those adjustments (a “Push-Out Election”). If a Push-Out Election is made, the Reviewed Year partners must pay any tax resulting from taking into account the adjustments and the partnership is not required to pay the imputed underpayment.
A Push-Out Election must be made no later than 45 days after the date a notice of final partnership adjustment (“FPA”) is mailed to the partnership by the IRS and may not be revoked without the consent of the IRS.
If a Push-Out Election is made, each Reviewed Year partner's tax is increased by the aggregate of the adjustment amounts and the Reviewed Year Partner must pay interest on such amounts. This increase in tax is reported on the return for the partner's taxable year that includes the date the statement is furnished to the partner by the partnership (the “Reporting Year”).
A partner that is furnished a statement in connection with a Push-Out Election may elect to pay a safe harbor amount (or the interest safe harbor amount, in the case of certain individuals). The safe harbor amounts are included on the statement in lieu of the additional Reporting Year tax.
If a partnership has more than one imputed underpayment it may make a Push-Out Election for some or all of the imputed underpayments. The partnership is responsible for paying an imputed underpayment for which it does not make the Push-Out Election.
A Push-Out Election generally requires the Reviewed Year Partners to provide information and to file amended returns. Appropriate provisions may need to be added to an agreement that ensures that partners who withdraw or sell their interests will continue to comply with these obligations.
Administrative Adjustment Requests by Partnership/LLC
If a partnership discovers errors on its return for a prior year, it can file an administrative adjustment request (an “AAR”) to correct those errors. Any adjustment requested in an AAR is taken into account for the partnership taxable year in which the AAR is made. Only a partnership may file an AAR. Therefore, a partner who is not also the partnership representative acting on behalf of the partnership may not file an AAR.
A partnership has three years from the later of the filing of the partnership return, or the due date of the partnership return (excluding extensions), to file an AAR for that taxable year. However, a partnership may not file an AAR for a partnership taxable year after the IRS has mailed a notice of an administrative proceeding with respect to that taxable year.
If an adjustment results in an imputed underpayment, the adjustment may be determined and taken into account in one of two ways. The partnership may determine and take the adjustment into account for the partnership taxable year in which the AAR is filed under rules similar to the payment of tax by the partnership on an imputed underpayment. Alternatively, the partnership and the partners may determine and take the adjustment into account under rules similar to the rules applicable where a Push-Out Election is made.
In the case of an adjustment that would not result in an imputed underpayment, the partnership and the Reviewed Year partners must determine and take the adjustment into account under rules similar to the payment of tax by a partnership on an imputed under payment. This provision ensures that the partners for the year to which the adjustments relate benefit from any refund that may result from such adjustments.
Partnerships/LLCs that Cease to Exist
If the IRS has determined that a partnership has ceased to exist before a partnership adjustment under the centralized partnership audit regime is made, the partnership adjustment is taken into account by the former partners of the partnership, unless the partnership has a valid Election Out in effect for the year to which the partnership adjustment relates.
The Proposed Regulations provide that a partnership has “ceased to exist” if the partnership terminates within the meaning of IRC Section 708(b)(1)(A) or does not have the ability to pay, in full, any amount that the partnership owes. The Proposed Regulations provide, however, that the IRS will not determine that a partnership has ceased to exist solely because: (i) a partnership has technically terminated under IRC Section 708(b)(1)(B); (ii) the partnership had made a valid Push-Out Election; or (iii) the partnership has not paid any amount the partnership is liable for.
State Tax Audits
Currently, the extent to which states will adopt the centralized partnership audit regime remains unclear. To the extent that a state does not adopt similar rules, state level audits would be conducted under very different rules than federal income tax audits, and the amount of tax, penalties and interest owed by each partner could differ significantly from the federal level.
Amendments to Partnership Agreements
Partnerships should amend their partnership agreements to reflect the centralized partnership audit regime prior to the end of the year. Unfortunately, there is no one size fits all language that can be used to make amendments. The types of provisions that partners will want to see adopted will depend, among other factors, on the nature of the partnership’s activities, whether the partner has management control over the entity, and whether the partner will be, or will control, the partnership representative. If the parties wait until the IRS initiates an audit, the current and former partners may have conflicting interests that may make it difficult to reach an agreement on amendments. In addition, it is important the partnerships identify and appoint a partnership representative for taxable years beginning after December 31, 2017.