The Bipartisan Budget Act of 2015 raises the federal debt ceiling and lifts mandatory spending caps on defense and domestic programs. It also makes sweeping changes to the rules for auditing partnerships. As a result of this legislation audits of master limited partnerships, investment funds and other business entities organized as partnerships are likely to increase.
More importantly, given the impact of the new audit rules, many partnership agreements will have to be amended. The new rules are effective for tax years beginning after December 31, 2017, but partnerships may choose to be governed by the new audit rules for any tax year beginning on, or after, November 2, 2015.
Background
Under previous law, partnerships could be audited in three ways:
1. Unified audit rules. Under the Tax Equity and Fiscal Responsibility Act (TEFRA) the tax treatment of any partnership item is generally determined at the partnership level. For partnerships with more than 10 members, the IRS conducts a single administrative proceeding to resolve audit issues regarding partnership items that are better determined at the partnership level rather than the partner level. After the audit is completed and the adjustments determined, the IRS recalculates the tax liability of each partner for the particular audit year.
While an administrative proceeding can resolve a partner-related issue, the IRS must still assess any resulting adjustment against the taxpayers who were partners in the year the misstatement of tax liability occurred. Partners may request an administrative adjustment, or a refund for their own separate tax liability and participate in partnership-level administrative proceedings.
2. Small partnership rules. The TEFRA unified audit rules described above do not apply to partnerships having 10 or fewer partners. Partners in a small partnership must be an individual (other than a nonresident alien), a C corporation or the estate of a deceased partner. However, these small partnerships may elect to have the unified audit rules apply. For small partnerships that do not make this choice, the IRS generally applies the audit procedures applicable to individual taxpayers.
3. Electing large partnership (“ELP”) rules. Simplified audit procedures apply to large partnerships with 100 or more partners who elect to be treated as ELPs for reporting and audit purposes. Under these rules, the IRS generally makes adjustments – at the partnership level – that flow through to the partners for the year in which the adjustment takes effect.
The current-year partners’ shares of income, gains, losses, deductions or credits are adjusted to reflect partnership adjustments that take effect in that year. Adjustments will not generally affect the prior-year returns of any partners, except in the case of changes to any partner’s distributive shares. A partner in an ELP must treat partnership items on their individual tax return so that they are consistent with the partnership return, even if the affected partner notifies the IRS of any inconsistencies.
The revised rules
Under the TEFRA unified partnership audit rules, unless a partnership elects to be taxed at the entity level, the IRS is required to pass audit adjustments through to the managing partners. Arguably the operational costs associated with the enforcement of this regime – where a majority of partnerships do not chose to be treated at the entity level – limits the number of partnership audits that the IRS can conduct. The changes are expected to make it easier for the IRS to audit large partnerships.
The budget act repealed the old TEFRA unified partnership audit and ELP rules and replaced them with a streamlined set of policies for auditing partnerships and their partners – and assessing and collecting any tax attributable to adjustments made in an audit at the partnership level. Thus, under this new approach, any adjustment to items of income, gain, loss, deduction or credit of a partnership for a partnership tax year – and any partner’s distributive share of such adjustment – is determined at the partnership level. Similarly, any tax attributable to such adjustments (including penalties, additions to tax or additional amounts that relate to an adjustment to any such item or share) is assessed and collected at the partnership level.
The new rules generally apply to tax years that begin after December 31, 2017. However, except for the opt-out rules for small partnerships, partnerships may elect to have the new law apply to any partnership return filed for partnership tax years beginning after November 2, 2015, but before January 1, 2018.
New audit process
The IRS will examine the partnership’s items of income, gain, loss, deduction or credit and partners’ distributive shares for a particular year of the partnership. Any adjustments will be taken into account by the partnership (and not the individual partner) in the “adjustment year” and collected at the partnership-level unless the partnership elects to pass these adjustments to its partners.
Partnerships must pay tax equal to the “imputed underpayment,” which is defined as the net of all adjustments for any reviewed year, multiplied by the highest individual or corporate tax rate. However, the imputed underpayment may be modified if a partnership can show that a lower amount is appropriate. The IRS can establish procedures to make such modifications where:
- A partner files an amended return for the tax year covering a period through the end of the reviewed year of the partnership, and the amended return takes account of the partnership adjustments, including payment of the taxes due;
- the partnership shows that part of the imputed underpayment is allocable to a partner who would not owe tax because it’s a tax-exempt entity; or
- the partnership shows that a part of the imputed underpayment is allocable to a partner who:
- in the case of ordinary income, is a C corporation, or
- in the case of a capital gain or qualified dividend, is an individual.
Any materials required by the IRS relating to decreased imputed underpayments must be submitted no later than the close of the 270-day period beginning on the date on which the notice of a proposed partnership adjustment is mailed, unless the IRS consents to an extension.
Additional aspects of the revised rules include:
Partner-level adjustment alternative. As an alternative to taking the adjustment into account at the partnership level, a partnership may chose – not later than 45 days after a notice of final partnership adjustment – to issue adjusted information returns to the reviewed-year partners. If this choice is made, the partners take the adjustment into account on their individual returns in the adjustment year via a simplified amended-return process. The election must be made in the time and manner prescribed by the IRS and can be revoked only with the IRS’s consent.
Administrative adjustment alternative. A partnership also has the option of requesting an administrative adjustment for a reviewed year, e.g., when it believes additional payment is due or an overpayment was made, with the adjustment taken into account in the adjustment year. The partnership would generally be allowed to take the adjustment into account at the partnership level, or issue adjusted information returns to each reviewed-year partner.
Administrative adjustment requests may not be filed more than three years after:
- The date on which the partnership return for such year is filed, or
- the partnership return due date for that year (determined without regard to extensions).
Consistency requirement. Under this rule each partner’s return items of income, gain, loss, deduction or credit attributable to a partnership in a manner consistent with the treatment of income, gain, loss, deduction or credit on the partnership return. Any underpayments due to non-compliance with the consistency rules will be treated as a mathematical or clerical error and, unless the affected partner files the appropriate notification, will be immediately collectible without a notice of deficiency.
Small partnerships’ election to opt-out of new rules. Partnerships with 100 or fewer qualifying partners may opt out of the new rules for any tax year. Each partner must be an individual, a C corporation, a foreign entity that would be a C corporation under U.S. law, an S corporation or an estate of a deceased partner. Small partnerships which are eligible and opt out will be audited under the rules applicable to individuals.
Impact on partnership agreements
Businesses and practitioners that are organized as, or represent, partnerships should become familiar with these revised partnership audit rules. The delayed date was designed to allow the IRS time to issue additional guidance on the new rules, or allow time for Congress to provide further clarifications (in the form of technical corrections) that cannot be resolved administratively.
However, since the new changes are a major shift from previous audit practices, clients should review and consider amending existing partnership and limited liability company (“LLC”) agreements, and modify future agreements to be prepared when the new rules take effect. Listed below are some potential issues that should be considered when revising partnership or LLC agreements:
- Ensuring that the small partnership election to opt out is available and protected whether or not the partnership makes the election.
- Details concerning the specific duties, authority and appointment of the partnership representative.
- Procedures that determine partner tax liabilities, especially liabilities that are assessed during the adjustment year. Consideration should be given to the impact on new partners, procedures that allow a partnership to issue amended K-1s to those who were partners during the review year and the impact on section 704(b) allocations and indemnities.
- How tax payments made by the partnership will be processed and collected.
- Whether an acquired partnership is considered a continuation of the partnership for tax purposes.
The impact of the new partnership audit regime will be significant for a majority of partnerships in areas ranging from tax and operations to legal issues and economic consequences. Many unanswered questions remain unresolved, and further technical corrections may be needed to clarify some provisions. In the meantime, partnerships, partners and advisors should remain informed and plan accordingly.
Published June 2, 2016.