On November 2, President Obama signed the Bipartisan Budget Act of 2015 (the “Act”), which significantly changes the procedures for tax audits of partnerships. The Act, which will be effective for tax years beginning after December 31, 2017, will replace the audit rules under the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”). The sweeping changes in the realm of partnership tax audits will likely require revisions to most partnership agreements and new considerations when entering or leaving a partnership.

Current Partnership Audit Procedures

Currently, partnerships and limited liability companies (“LLCs”) taxed as partnerships are subject to audit procedures adopted under TEFRA. The primary procedures under TEFRA are:

  • The IRS conducts a single examination of the tax treatment of partnership items at the partnership level.
  • When the IRS makes an adjustment for a year under audit, the partners associated with the partnership for that audited year are separately responsible for paying any taxes due. 
  • Each partnership must have a designated tax matters partner (“TMP”). The TMP must be a partner of the entity and will represent the partnership in dealings before the IRS, manage audit investigations, and provide tax information to other partners.
  • Certain partners are designated as “notice partners.” Partners, who qualify as “notice partners” have the right to petition the Tax Court for an adjustment, receive notices of adjustments from the IRS, and begin proceedings if the TMP has not done so.

Partnership Audits Under New Procedures

The new partnership audit procedures generally become effective January 1, 2018 (a partnership can elect to apply them earlier). These procedures will apply to all entities that are treated as partnerships for federal income tax purposes, primarily partnerships and LLCs. 

Some key features under the new regime are:

  • The IRS will assess tax adjustments from audits at the partnership level rather than at the partner level. The new entity-level tax of the partnership will have adverse consequences on persons who are partners in the year that the audit (or any judicial review) is completed. 
  • The procedures provide for an alternative method under which the partnership can elect to impose the liability of the underpayment on the partners for the tax year to which the adjustment relates. 
  • The new procedures replace the TMP with a “partnership representative” who has different rights and responsibilities.
  • Partnerships with 100 or fewer qualifying partners may opt out of the new partnership procedures.

“Opt Out” Election

Under the new procedures, certain partnerships with 100 or fewer qualifying partners during a tax year can make an “opt out” election for that tax year. Generally, to be eligible to make this election the partnership must meet the following requirements:

  • Each of the partners of the partnership must be either an individual, a C corporation (or a foreign entity that would be treated as a C corporation were it domestic), an S corporation, or an estate of a deceased person.
  • No partner may be an entity taxed as a partnership.
  • The partnership must furnish 100 or fewer Schedules K-1 with respect to its partners. 

If the partnership is eligible to “opt out” under the new procedures and makes the election on a timely filed tax return, the partnership and its partners will likely be audited under the general rules applicable to individual taxpayers. The “opt out” election applies only with respect to the tax year for which it is made, and therefore must be made every year where desired. If the partnership cannot or does not elect to “opt out” then one of the following partnership level assessment methods will apply. 

Partnership Level Assessment—Default Method

Under the default method, the IRS will assess and collect tax adjustments at the partnership level in the year that the audit is completed (the adjustment year). The default method will place the economic burden of the additional tax liability on the current partners in the partnership instead of on those persons who were partners for the year under audit.

The IRS will determine the additional tax liability attributable to a partnership level adjustment by netting all adjustments and multiplying the net amount by the highest tax rate in effect for the reviewed year (currently 39.6 percent), regardless of the tax status of the partners. However, the partnership can provide information to support a lower tax liability (for example, the presence of a tax-exempt partner).  

Partner Level Assessment—Alternative Method

As an alternative to the default method, the partnership may elect out of the partnership level assessment and shift the tax liability to the partners during the tax year to which the adjustment applies. This can be accomplished by issuing adjusted Schedules K-1 to the those persons who were partners during the reviewed year within 45 days after the IRS issues a notice of final judgment. Under this method, each reviewed year partner would then take the adjustment into account in calculating its tax liability. A drawback to electing the alternative method is that interest is determined at a rate that is 2 percent higher than the normal deficiency rate. Interest will accrue from the due date of the tax return for the taxable year at issue. 

Partnership Representative Replaces the Tax Matters Partner

The new rules eliminate the designation of a TMP and instead require each partnership to select a partnership representative (“PR”). Unlike the TMP under TEFRA, the PR does not need to be a partner. The only prerequisite is that the PR has “a substantial presence in the United States.” If the partnership fails to select a PR, the IRS has the authority to do so. Furthermore, the new rules eliminate the concept of a “notice partner.” As a result, the PR’s actions will bind the partnership and all its partners. The PR’s exclusive right to resolve partnership audits and disputes may create serious tensions if the PR’s rights are not specified in the partnership agreement.


Commentators believe that these new audit procedures are likely to lead to an increase in the number of partnership audits. Existing and new partnership agreements should be reviewed and in some cases revised to address aspects of the new rules. Some key issues for current and new partners to consider in amending a partnership agreement (or LLC operating agreement) are the following:

Potential revisions to existing partnership agreements:

  • Designate a partnership representative.
  • Specify the authority of the partnership representative.
  • Determine whether to “opt out” or elect the alternative method if the “opt out” election is not available.
  • Include provisions that prevent partners from assigning interests to any entity treated as a partnership for U.S. tax purposes.
  • Add special allocation provisions to equitably allocate audit adjustments absorbed at the partnership level.

Considerations for potential acquirers of partnership interests:

  • Perform additional due diligence regarding the partnership’s prior tax returns in consideration of the shift of liability from former partners to current partners under the new regime. 
  • Potentially request representations and indemnities from the seller of the interest with respect to any pre-closing taxes or penalties.