The U.S. Treasury Department and the Internal Revenue Service (the “IRS”) have re-issued proposed regulations (the “Proposed Regulations”) on the new centralized partnership audit rules enacted as part of the Bipartisan Budget Act of 2015 (the “New Partnership Audit Rules”). The Proposed Regulations are nearly identical to proposed regulations on the New Partnership Audit Rules previously issued in January, which were withdrawn soon after issuance following an executive order from the Trump Administration. The New Partnership Audit Rules will mandatorily apply to partnerships for tax years beginning on or after January 1, 2018. See prior coverage of the New Partnership Audit Rules.
The New Partnership Audit Rules
The New Partnership Audit Rules were enacted to simplify IRS audits of large partnerships (including LLCs treated as partnerships for tax purposes). Under the current (and soon to be outdated) rules governing partnership audits (enacted as part of the Tax Equity and Fiscal Responsibility Act of 1982, or “TEFRA”), the IRS generally will determine audit adjustments to partnership items in unified proceedings at the partnership level, and then must separately make adjustments to the applicable partners’ share of partnership income, calculate the additional tax due with respect to each partner, and only then collect the tax underpayments from the partners. The most significant change in the New Partnership Audit Rules is to permit the IRS to assess tax directly against the partnership in the year of the review, thereby shifting tax liability from the partners to the partnership itself. In addition, the new rules will streamline the method by which the IRS can assess tax from adjustments of partnership items.
Partnerships and partners should be aware that the New Partnership Audit Rules may result in more tax liability when paid by a partnership as a result of an audit adjustment, compared to the amount of tax that would be due by the partnership’s partners or former partners under the outgoing TEFRA rules. Furthermore, the requirement that the partnership itself pay tax arising from an audit adjustment may, absent an indemnification provision in the partnership or LLC agreement, effectively shift the burden of the tax liability from the partnership’s partners or former partners for the tax year under review (“reviewed-year partners”) based on the allocations for that year, to the partnership’s current partners based on their interests when the partnership level tax becomes due, with the current partners essentially treating the tax as a non-deductible current period expense. Although the New Partnership Audit Rules contain mechanisms to mitigate these inequitable effects, including the ability of certain partnerships to opt-out of the rules altogether, not all partnerships will be eligible to opt-out of these rules or to fully mitigate these effects.
The Proposed Regulations
The topics principally addressed in the Proposed Regulations are grouped into the following categories: the scope of the New Partnership Audit Rules, including opting out of the new rules; consistent treatment of partnership items by partners; the new “partnership representative;” imputed underpayments and modification of imputed underpayments; the election to “push-out” partnership adjustments to reviewed-year partners; and administrative adjustment requests. These topics are addressed in more detail below.
Electing Out of the New Partnership Audit Rules
A partnership must satisfy two requirements to be eligible to elect out of the New Partnership Audit Rules (an “eligible partnership”): it must have 100 or fewer partners, and each of its partners must be an eligible partner, that is, an individual, a C corporation (including a non-U.S. entity classified as a C corporation), an S corporation, or an estate of a deceased partner. Neither a partnership nor a “disregarded entity” is an eligible partner, and therefore a partnership with either another partnership or a disregarded entity as a partner is not an eligible partnership. A partnership is considered to have 100 or fewer partners during the taxable year if it is required to issue 100 or fewer Schedule K-1s to its partners, taking into account any statements required to be issued by an S-Corporation partner to its shareholders.
The Consistency Requirement
While not an audit matter, the New Partnership Audit Rules require partners to treat partnership items the same way as those items are treated by the partnership as reported on the original partnership return filed with the IRS, or notify the IRS of any inconsistent treatment, typically at the time the partner files its tax return on which the item is treated inconsistently. Where a partner fails to abide by this rule, the IRS may assess and collect any underpayment resulting from inconsistent reporting from the partner under expedited procedures, as if the inconsistency was the result of a mathematical or clerical error.
The Partnership Representative
Under the TEFRA rules, a “tax matters partner” (“TMP”) is responsible for representing the partnership in partnership audits. The New Partnership Audit Rules replace the TMP with a “partnership representative,” who has sole authority to act on behalf of the partnership under the New Partnership Audit Rules, and who may bind the partnership and its partners in dealings with the IRS. Any person (including an entity, or a non-partner) may serve as partnership representative, provided that person has a U.S. taxpayer identification number, is able to meet with the IRS in the United States at a reasonable time and place, and meets other requirements. The Proposed Regulations provide that, if a partnership appoints an entity as partnership representative, the partnership must also appoint an individual (the “designated individual”) who satisfies the requirements for being a partnership representative, to act on behalf of that entity.
Partnership Level Underpayments
Under the New Partnership Audit Rules, the amount of an underpayment of tax required to be paid by a partnership as a result of an audit generally equals the sum of all net positive adjustments resulting from the audit (determined under grouping and netting rules set forth in the Proposed Regulations), multiplied by the highest rate of tax applicable to individuals or corporations in effect for the reviewed year, plus interest and applicable penalties. (Note that these grouping and netting rules may cause such underpayment to exceed what the reviewed-year partners’ aggregate additional tax liability would have been had such partners reported their incomes consistently with the results of the audit. For example, where an item is reallocated from one partner to another, the two adjustments – the increase in the amount of the item to the first partner and the decrease in the amount of the item to the second partner – generally may not be netted against each other, thus giving rise to a net positive adjustment and an underpayment of tax.) The underpayment of tax may be reduced in several situations, including where (i) a partner has amended its return to take into account its share of items resulting from the adjustment, (ii) the partnership is able to demonstrate that some of its partners in the reviewed year were tax-exempt and that the income would not be taxable to such partner (e.g., not unrelated business taxable income), or (iii) the partnership is able to demonstrate that a lower rate of tax applies to an item (e.g, because it is attributable to an individual and is an item of capital gain or qualified dividend income, or is attributable to a corporation which is taxable at the lower corporate income tax rate). An adjustment not resulting in an underpayment of tax is generally taken into account in the year of the review as an adjustment to the partnership items allocated to the current partners.
Election to “Push-Out” Partnership Adjustments to Reviewed-Year Partners
A partnership may, in certain circumstances, avoid paying the tax due for the adjustment year by electing to “push out” the adjustment to its reviewed-year partners. To make this election the partnership must report a U.S. taxpayer identification number for each partner, including foreign partners. If the partnership pushes out the adjustment to its reviewed-year partners, each affected partner is obligated to take the adjustment into account in the reviewed year by either (1) calculating the increase in the partner’s tax owed in the reviewed year and in all intervening years as a result of the adjustment, or (2) paying a safe harbor amount that is calculated by the partnership. In addition, the underpayment rate used to calculate the reviewed-year partners’ liability for interest on underpaid tax will generally be 2 percentage points higher than that which would apply if the partnership itself pays the underpayment. The Proposed Regulations do not permit a “push out” adjustment to be made through tiered partnerships, and reserve on this topic for future proposed regulations.
Administrative Adjustment Requests
The Proposed Regulations provide that a partnership may choose to proactively correct an error it discovers in a return that it previously filed by filing an administrative adjustment request (“AAR”) with the IRS. The rules in the Proposed Regulations for how a partnership takes into account adjustments resulting from AARs are generally similar to the rules applicable to audit adjustments. For example, a partnership generally will be required to pay the underpayment resulting from the AAR in the adjustment year or, in certain circumstances, may elect to push out the adjustment. However, several differences exist, including the fact that partners would not have the option to pay a safe harbor amount, and that the 2 percentage point increase in the underpayment interest rate would not apply to these partners.
Issues Left Unaddressed by the Proposed Regulations
Several issues relevant to the implementation New Partnership Audit Rules are left unaddressed by the Proposed Regulations, including how the new centralized partnership audit rules will be coordinated with existing withholding obligations, as well as the application of the New Partnership Audit Rules to tiered partnership arrangements. The Treasury Department and the IRS stated in the preamble to the Proposed Regulations that the latter issue may be the subject of other proposed regulations in the near future. In addition, the Treasury Department and the IRS requested comments describing situations in which a foreign partner in a partnership subject to the New Partnership Audit Rules would not, other than for purposes of allowing the partnership to opt-out of the new rules, be required to have a taxpayer identification number.
Review and Amendment of Existing Partnership Agreements
In most cases the sweeping nature of the New Partnership Audit Rules and their economic effects to partners will necessitate careful review of, and possible amendment to, existing partnership or LLC agreements.