The arcane rules surrounding partnership audits rarely, if ever, come up, and most people don’t even know that they exist. What once was a set of rules confined to the dark recesses of the Internal Revenue Code are now coming to the fore as new rules have been issued, which radically change how partnership audits are being conducted, and, more importantly, who bears the liability.
The new rules make it clear that IRS is a lot more focused on partnership audits, and the IRS is taking a heavy-handed approach to making its life easier when auditing partnerships. Importantly, under this new system of rules, partnerships (rather than individual partners) will be assessed by default, and the amount assessed will apply to the adjustment year rather than to the year or years in review. Further, the tax will be imposed at the highest rate then in effect for individuals or corporations. The message is that the IRS is no longer in the business of chasing after individual partners; rather it is going directly to the source (the partnership itself) and applying a tax at the highest rate possible. As a result the BBA rules may have a profoundly negative effect on a partnership’s bottom line and the take-home amounts for the existing partners who may not have even been associated with the partnership during the tax year in question.
Brief Background on the Recent Audit Rules
Since 1982 partnership audits have been governed by the unified audit procedures enacted under the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”). TEFRA was designed to streamline the audit process for partnerships by providing that the tax treatment of partnership items would be generally determined at the partnership level rather than the partner level. However, any resulting assessments and collections of tax would be made at the partner level, and only taxpayers who were partners of the audited partnership in the year of review would be impacted. In practice, TEFRA proved to be cumbersome, and it ultimately created more administrative problems than it fixed. Moreover, TEFRA, as applied to partnerships, failed to increase the government coffers by any appreciable amount.
The government responded to TEFRA’s shortcomings by enacting the Bipartisan Budget Act of 2015 (the “BBA”), which repealed TEFRA and completely revamped the partnership audit rules. The BBA audit rules apply to partnership tax years after December 31, 2017, but partnerships may elect to have these rules apply to them early. By targeting partnerships at the entity level, the BBA creates a more centralized audit and collection process that lightens the administrative burden for the IRS. Unfortunately, the BBA is rather byzantine and leaves a lot to be desired in terms of practical guidance. Also muddying the waters is the fact that proposed regulations issued by the IRS in January that were designed to address some of the gaps and unanswered questions posed by the BBA are on hold due to the Executive Order freezing all proposed regulations.
Major BBA Changes—More Tax and Carrying the Water for Other Partners
Two key terms every partner should keep in mind when it comes to the BBA are the “adjustment year” and the “reviewed year.” The adjustment year is generally the year in which the IRS sends notice of a final partnership adjustment. The reviewed year is the partnership tax year under audit. With that in mind, an understatement of income may occur in a partnership’s 2018 tax year (the reviewed year), and the final adjustment relating to an imputed understatement may be imposed in the partnership’s 2020 tax year (the adjustment year). By default, under the BBA, an assessment of additional tax impacts the partnership and its owners who are partners only in the adjustment year. The reviewed year may have been a few years prior to the adjustment year, and the partner makeup at that time may have been different. This has the potential to create a disparity in treatment of partners in the reviewed year and partners in the adjustment year. In my example, a partner in 2020 may ultimately bear a portion of the partnership’s tax liability even if such partner was not an owner in 2018. Further, if a person was a partner in the partnership in 2018 (and received the economic benefit of bearing lower taxes than what was determined to be correct), but is no longer a partner in the partnership in 2020, such partner may escape the impact of the imputed understatement under the BBA completely. This represents a seismic shift in the treatment of partners from the old TEFRA rules. To add salt to the wound, because the tax is imposed on the net adjustment at the highest rate for individuals or corporations at the partnership level, the liability amount is potentially much greater than it would be under TEFRA. This is due to the fact that under the old TEFRA rules the amount of understatement tax was assessed at the partner level and would take into account a subject partner’s marginal tax bracket, available losses, credits and other attributes.
Another key term every partner should know about is the “partnership representative.” The partnership representative is a person or entity with substantial presence in the United States that is designated to be the partnership’s liaison with the IRS in the event of an audit. The partnership representative has immense power under the BBA and is the only one that may represent the partnership during audit negotiations and settlement. Further, the partnership representative is the only one who can make elections on behalf of the partnership and bind the partners in an audit proceeding. This is a significant departure from the old rules pertaining to “tax matters partners” or “tax matters members” who filled a similar role but were required to notify the other partners at key stages of the audit and allow them to participate in the audit and negotiation of settlement.
Elections and Modifications—Relief from the BBA Default Rules
A partnership that issues less than 100 K-1s in a given tax year may elect out of the BBA, but here is the catch: all of its partners must be individuals, C corporations, S corporations, estates of deceased partners, or foreign entities that would be C corporations if they were domestic entities, and certain tax-exempt organizations. Under these rules and the proposed regulations, other partnerships (including limited liability companies), trusts, ineligible foreign entities, disregarded entities, nominees or similar persons holding an interest on behalf of another person and estates that are not estates of a deceased partner are specifically excluded. Therefore, the types and number of partnerships that would be able to take advantage of this election are very limited. If a partnership is able to make this election, each of its partners would be subject to separate audit procedures as they existed prior to TEFRA. All in all, this election may be most desirable for corporate joint ventures with few partners. Tiered partnership relied upon by most private equity groups and other investment funds would be precluded from making this election.
Another election that is available is the so-called “push-out” election which allows the partnership to push out the items adjusted at the partnership level to the partners who were partners in the reviewed year. The good news here is that only the adjustment year partners who were also reviewed year partners will bear the tax liability, although it is unclear what happens if they fail to pay the full amount. Further, because the pushed-out adjustment items will be reported by the reviewed year partners, their tax attributes would apply. The bad news is that this election must be made within 45 days of the date of the notice of final partnership adjustment, and the partnership has to report the adjusted items to the reviewed year partners. Further, the interest rate for any tax deficiency is increased by two percentage points, and the reviewed year partners will have to account for additional tax liability between the reviewed year and the adjustment year occasioned by the partnership adjustment items.
In addition to the two elections noted above, there are procedures under development that would allow a partnership to reduce its imputed underpayment under the default BBA rules by showing that the adjustments would be less if the partnership and the partners had correctly reported the adjustment items. This may be accomplished, for example, by showing that an adjustment item is subject to capital gain or allocable to a tax exempt organization. However, to make this showing, it is incumbent upon the partners to provide all necessary information to back this up.
Lastly, the partnership tax liability under the BBA default rules may be mitigated if one or more partners file an amended return to properly take into account all adjustment items and pay the additional tax. Without any kind of obligation of a partner to file an amended return, however, this option may be a challenge to partnerships whose reviewed year partners have disappeared or are recalcitrant.
Be Proactive—Things You Can Do to Mitigate the Risk
Given the changes ushered in by the BBA and the partnership representative’s unfettered discretion to negotiate and settle an audit without having to keep the other partners informed, partners and potential partners should be thinking first and foremost about ways to mitigate their risk. In this spirit, it is essential that the partnership or limited liability company agreement that you sign provides contractual parameters around the areas affected by the BBA. Here are a few things to look for or demand to see in your partnership or limited liability company agreements:
- Contractual obligations that would require the partnership representative to share information among the partners and keep them informed about the audit process;
- Processes for the approval and removal of a partnership representative;
- Qualifications for the partnership representative;
- Limiting the partnership representative’s ability to make an election under the BBA, negotiate or settle an audit, or make a modification without prior approval from other partners;
- Diligence parameters for partnership representatives;
- Requirements for existing and former partners to respond to requests for information by partnership representatives;
- Transfer restrictions that to preserve the ability of a partnership to elect out of the BBA;
- The manner in which partnership-level tax liabilities will be allocated to, borne by, and collected from the partners or former partners; and
- Indemnification provisions that survive a partner’s status as a partner and address:
a. The failure of a partner or former partner to cooperate in good faith in connection with a partnership audit;
b. The failure of a partner or former partner to file an amended return if requested by the partnership representative;
c. The failure of a partner or former partner to satisfy such partner’s tax liability resulting from an amended return or push-out election; and
d. The failure of a partner or former partner to take into account such partner’s share of partnership adjustment items.
For those who are purchasing partnership interests from an existing partner, you may want to negotiate seller representations and warranties around prior-period partnership tax liabilities. On the other hand, if you are a potential seller, you may want to negotiate ways to prevent a push-out election or at least secure notice and participation rights for reviewed years in case the partnership makes a push-out election that implicates you.
The BBA rules represent a sea change in the ways partnerships are audited, and a partner’s bottom line is more at risk than before. The old TEFRA rules are gone as of January 1, 2018, and partners can no longer take a passive interest in how the partnership audit rules will impact them. While the new rules are dense, current partners, would-be partners, and even former partners should have a working knowledge of these rules so that they appropriately protect themselves through contractual means.