President Obama has signed into law tax extenders legislation, entitled the Protecting Americans from Tax Hikes Act of 2015 (the PATH Act), which will extend more than 50 expiring provisions of the Internal Revenue Code. Section 411 of the PATH Act sets out technical clarifications and corrections to the new rules governing partnership audits and litigation that were enacted on November 2, 2015 as part of the Bipartisan Budget Act of 2015 (the BBA).
As practitioners continue to identify more and more issues with the new partnership audit and litigation rules, Congress has responded by making several significant amendments to the BBA, including:
- adding a new procedure that allows publicly traded partnerships to reduce their tax liability by taking into account “specified passive activity losses”
- correcting a procedure to allow a partnership to reduce its tax liability in any case where it has an adjustment allocated to a partner that is a C-corporation (and not solely where such partner is allocated ordinary income) and
- clarifying that a partnership retains the right to seek judicial review of final partnership adjustments when it elects to shift its liability to its partners.
The BBA repealed the existing partnership audit regime that was enacted as part of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) and replaced it with a streamlined set of rules that apply to all partnerships, unless a partnership is eligible to elect out and timely makes such an election. The new rules, which are effective for returns filed for partnership taxable years beginning after December 31, 2017, represent a significant departure from the TEFRA audit procedures and will impact both new and existing operating agreements for all entities taxed as partnerships for federal income tax purposes, including limited liability companies.
THE NEW DEFAULT REGIME: ENTITY LEVEL TAX COLLECTION
Under TEFRA, the tax treatment of “partnership items” is determined in a partnership-level proceeding. Once the adjustments to partnership items have become final, the IRS may undertake further proceedings at the partner level in order to make any resulting adjustments in the tax liability of the individual partners that held an interest in the partnership in the year under review and collect any tax liability (including interest and penalties) from the affected partner.
Under the new default regime, the IRS will continue to examine a partnership’s items of income, gain, loss, deduction, and credits and make any adjustments at the partnership level. However, if the resulting adjustment creates an underpayment of tax (referred to as an “imputed underpayment”), the IRS will assess and collect the imputed underpayment (and any interest and penalties) from the partnership itself (and not the individual partners). The amount of the imputed underpayment will generally be computed by netting the amount of all adjustments, and multiplying the amount of net underreported income by the highest marginal income tax rate for the taxable year in which the item was reported by the partnership on its return (the “Reviewed Year”). This amount is then assessed and collected from the partnership in the year that such audit or any judicial review is completed (the “Adjustment Year”). These new audit procedures effectively shift the burden for tax deficiencies from partners who held an interest in the Reviewed Year to the partners who own an interest in the partnership in the Adjustment Year.
A partnership may reduce (under procedures to be specified by Treasury) its imputed underpayment by demonstrating that some of its partners are subject to a lower rate or are tax-exempt. The law previously specified that such a procedure was only available in cases when an adjustments gave rise toordinary income allocated to a partner that is a C-corporation, or capital gain or qualified dividend income allocated to a partner that is an individual.
The PATH Act amends this limitation by allowing the partnership to reduce its imputed underpayment provision in any case that it has an imputed underpayment allocated to a partner that is a C-corporation (and not solely where such partner is allocated ordinary income). Furthermore, the PATH Act added a new procedure for publicly traded partnerships to reduce the amount of imputed underpayment by the portion of such underpayment attributable to a net decrease in “specified passive activity loss” allocable to certain partners that are affected by the passive activity loss rules.
Finally, the new default regime provides a procedure for the partnership to reduce the amount of its imputed underpayment to the extent that its partners voluntarily file amended tax returns and pay any resulting deficiency in tax arising in the Reviewed Year. In cases where any adjustment reallocates the distributive share of any partnership item from one partner to another, all the partners will be required to file amended returns (and pay resulting tax deficiencies) for this procedure to apply. Because this procedure requires that all of the partners in a partnership file amended returns, it is unlikely that it will be of practical use for larger partnerships.
ELECTING OUT OF THE NEW DEFAULT REGIME
There are two ways by which a partnership may elect out of the new default regime, thereby avoiding entity-level taxation and collection.
First, certain small partnerships may make an annual election (on a timely filed return) to opt out of the regime entirely (the “Small Partnership Election”). For this purpose, a “small” partnership must have 100 or fewer partners, and must be composed entirely of individuals, C-corporations, S-corporationss, foreign entities treated as a C-corporations, or estates of deceased partners. This election, however, is not available to a partnership composed of partners treated as flow-through entities, including partnerships or limited liability companies.
Second, if an audit results in adjustments with respect to a partnership that has not made the Small Partnership Election, then the partnership may avoid paying the resulting imputed underpayment by shifting the liability to its partners (the “Alternative Method”). A partnership electing into the Alternative Method will be required to furnish a statement (to be specified by the Treasury) to both the IRS and each of its partners in the Reviewed Year that reflects such partner’s distributive share of any resulting adjustment from the partnership audit. This election effectively allows the partnership to shift its imputed underpayment up to its historic partners.
Existing entities that are taxed as partnerships should consider whether changes to partnership agreements are necessary in order to require that the Small Partnership Election be made, or that the partnership elect into the Alternative Method, or in the absence of making such any such election, seeking indemnification from historic partners for tax, interest, or penalties that may arise in a Reviewed Year. Newly formed entities should consider adopting appropriate protections for sponsors and investors alike at the outset to minimize contentious issues in the future.
OTHER PROCEDURAL CHANGES
The new partnership audit rules also changed several significant procedural aspects of how the IRS conducted partnership audits under the TEFRA regimes. First, the concept of a tax matters partner (TMP) has been replaced with the concept of a “partnership representative.” There are several significant distinctions between a TMP and a partnership representative. In particular, unlike a TMP, a partnership representative does not need to be a partner of the partnership. Instead the only requirement is that a partnership representative must have a substantial presence in the United States. Second, the IRS is only required to provide notice of a partnership audit proceeding or proposed or final partnership level adjustment to the partnership representative. As a result, the partnership representative has the exclusive right and sole responsibility to take action in response to an IRS audit or adjustments, which includes making electing into the Alternative Method, petitioning the United States Tax Court, or settling with the IRS. This places the partnership representative in a powerful position; therefore, practitioners and partners should consider whether to establish limitations and parameters in the partnership agreement that specify what actions the partnership representative can take during the course of an administrative or judicial proceeding without the approval of the partnership’s partners, and when such approval will be required.
CONCLUSION: 7 POINTS TO CONSIDER
Even after the recent technical clarifications and corrections set forth in Section 411 of the PATH Act, there are still many provisions of the new partnership audit and litigation procedure that remain unclear and require guidance. While Treasury or the IRS should issue guidance before the effective date, practitioners and other interested parties should begin to evaluate partnership agreements of new and existing partnerships, and any agreements to purchase an interest in any partnership, to consider whether any such agreement should:
- Require that the partnership elect out of the new default regime either by using the Small Partnership Election or the Alternative Method
- Require that the partnership representative provide notice to the partners of the beginning of an IRS examination and/or IRS proposed or final partnership adjustment
- Create clear parameters or restrictions on the partnership representative in order to ensure that it takes certain actions depending on the stage of the administrative or judicial proceeding
- Allocate the costs and expenses of external accountants and lawyers incurred by the partnership representative during an examination or litigation to certain partners
- Set forth procedures for replacing the partnership representative if it fails to act or becomes incapable of acting in its capacity as a partnership representative
- Require cooperation among the partners to ensure that the partnership is able to reduce the amount of its imputed underpayment liability and
- Contain covenants or indemnities to protect current partners against historic liabilities.
The changes to the rules governing partnership audit and litigation procedures are sweeping. It is reasonable to expect that questions will arise as Treasury or the IRS issues formal and informal guidance with respect to these new procedures.