This revamp of partnership audit rules impacts every partnership and limited liability company taxed as a partnership.
The new partnership audit rules (the “New Rules”), as enacted by the Bipartisan Budget Act of 2015, became effective for most partnerships on January 1, 2018. The Internal Revenue Service (“IRS”) issued guidance on the New Rules in the form of proposed regulations published on July 10, 2017.
The new federal partnership tax audit regime dramatically changes the landscape for entities taxed as partnerships by making partnerships, and not the partners, liable for payments of any federal taxes assessed as a result of an audit at the partnership level. Prior to the New Rules, the IRS was required to collect any underpayment of United States federal income tax (including penalties and interest), owing as a result of an audit of the partnership, directly from the partners and not the partnership. Thus, one of the primary effects of the New Rules is to relieve the IRS of the burden of having to pursue individual partners to collect taxes (and any associated penalties and interest) assessed as a result of income tax audits of the partnerships.
Additionally, the New Rules attempt to simplify and streamline the procedures for auditing all partnerships by requiring partnerships to designate a representative to act on their behalf.
This revamp of partnership audit rules impacts every partnership and limited liability company taxed as a partnership. It is strongly recommended that every entity treated as a partnership for federal income tax purposes revise its operating documents(s) (e.g., partnership agreement or operating agreement) to address the issues that arise with respect to the New Rules.
Prior to the New Rules, partnerships generally were required to appoint a “tax matters partner” to represent the partnership in connection with federal income tax audits. The New Rules eliminate this concept and now require that each partnership designate a “partnership representative,” who will have the sole authority to act on behalf of the partnership in connection with an audit or judicial procedures without the consent of the partners.
It is worth mentioning that, unlike a “tax matters partner” under the old rules, the “partnership representative” need not be a partner so long as such person has substantial presence in the United States. This change is beneficial especially for certain investment vehicles that can now appoint a non-partner management company or investment advisor to act as the “partnership representative.”
Given these changes, we recommend that individual partners seek to amend governing documents and strengthen contractual protections addressing issues that may arise in connection with federal income tax audits or judicial procedures. Such protections may include covenants requiring the “partnership representative” to (i) provide information and/or notices relating to federal income tax audits or judicial procedures or (ii) obtain consent from the partners before acting in any way that could bind the partnership.
Responsibility for Imputed Underpayment
The IRS is no longer required to individually assess each partner’s share of any tax due as a result of a partnership audit. Pursuant to the New Rules, the partnership itself is responsible for imputed underpayment. Fundamentally, this means that the current partners at the time of the audit are responsible for the payment of the tax imputed for the tax year being audited, even if there were different partners for the tax year that was reviewed by the IRS. This could present a mismatch of the tax burden among the partners for that period. Partnerships may wish to address liabilities arising from this change by contractually providing for indemnity and reimbursement obligations from current and former partners.
There is a limited exception for certain eligible partnerships to opt-out of the New Rules. Such an election may be made only if the following requirements are met: (i) the partnership has 100 or fewer partners, and (ii) each partner is an individual, a decedent’s estate, a C corporation, an S corporation or a foreign entity that would be treated as a C corporation if it were a domestic entity. The opt-out election is not available to partnerships that have an entity taxed as a partnership as a partner.
An eligible partnership may opt-out of the New Rules for a taxable year by making an election on its tax return (timely filed, with extensions) and notifying each of its partners within 30 days of making such election. If no opt-out election is made, the New Rules apply to all partners in the partnership.
Partnerships may also elect to push-out the obligations, meaning that a partnership may choose to shift the obligation to pay any imputed underpayment (and any penalties, interest and additional tax) to the partners of the partnership during the reviewed year. The partnership is required to make the push-out election within 45 days of the date of the notice of final partnership adjustment from the IRS. Under the New Rules, if choosing the push-out election, the partnership must furnish amended Schedule K-1s to the review year partners. Under this election, penalties, interest and additions to tax are paid by each partner of the review year. We recommend that the governing agreement for a partnership or limited liability company include language under which review partners agree to cooperate with a push-out election by filing amended returns and paying any taxes, interest and penalties (even if they are no longer partners or members).
The implication of the New Rules is significant and partnerships that have not amended or revised existing operating documents should consider doing so for both economic and control of partnership reasons.
For Further Information
If you have any questions about this Alert, please contact David A. Sussman, Lisa C. Merrill, Driscoll R. Ugarte, Anastasios G. Kastrinakis, Angela K. Santos, Yosef B. Shwedel, Maximilian Viski-Hanka; an attorney in the Tax Practice Group; an attorney in the Corporate Practice Group; or the Duane Morris practitioner with whom you are in regular contact.
Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.