New Partnership Audit Rules
Any partner in a partnership, or member in a limited liability company that is taxed as a partnership, needs to be aware of some major changes that took effect January 1, 2018 with respect to how partnerships are audited. The Bipartisan Budget Act of 2015 (BBA) introduced a new regime to govern partnership audits, which was intended to streamline partnership audits and raise tax revenue. This post will give you a 50,000-foot view of the changes and explain why most existing partnership and operating agreements need to be amended. (For simplicity, I will only refer to partnerships and their partners from here on, but all of these changes and considerations are equally applicable to limited liability companies treated as partnerships for purposes of federal tax law and their members.)
The Bipartisan Budget Act of 2015 (BBA) introduced a new regime to govern partnership audits, which was intended to streamline partnership audits and raise tax revenue.
A foundational principle of partnership taxation is that, technically, partnerships are not taxpayers. The rules of Subchapter K of the Internal Revenue Code provide a complex pass-through regime of taxation for partnerships. Business entities taxed as partnerships do not pay tax on their income; instead, the partnership is treated as a conduit through which income and loss flow to its partners. This idea is summed up in § 701, the first section of Subchapter K: “A partnership as such shall not be subject to the income tax imposed by this chapter. Persons carrying on business as partners shall be liable for income tax only in their separate or individual capacities.”
Because the taxpayers are the partners, the Service originally had to audit each partner separately with respect to partnership items. As partnerships grew in popularity, this led to serious administrative issues. The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) created rules to mitigate the administrative and judicial burdens of treating each partner individually. Partnerships appointed a “tax matters partner” as a representative in federal tax proceedings. Importantly, partners maintained the right to be informed of important developments and to participate in the proceedings themselves. Once an adjustment of a partnership item was made, the Service still collected any tax liability from the partners.
The new partnership audit rules under the BBA apply for tax years beginning after December 31, 2017 and centralize audits at the partnership level. These rules apply to all partnerships (subject to one narrow exception discussed below) and mark a significant change in the treatment of audited partnerships.
Liability at the Partnership Level
The new general rule is that all adjustments to partnership items are determined at the partnership level, and any tax, interest, or penalties that may be due will be accessed and collected at the partnership level. As explained above, this treatment diverges from the long-established principle that partnerships are conduits for allocating taxes to partners rather than separate taxpaying entities themselves. Additionally, the partnership is to take the amounts due into account for the “adjustment year” (when the adjustment is finalized) rather than for the “reviewed year” (the year that was adjusted).
Alternatively, there are two ways that the liability for adjustments may be shifted back to the partners for the reviewed year. First, the partnership may elect to have the partners take into account any adjustments at the partner level. This “push-out” election must be made within 45 days of a final adjustment and is only available to the extent that the partnership provides certain information with respect to each of its partners to the Service. A second way to remove the liability from the partnership is for all of its partners for the reviewed year to file amended tax returns taking into account their share of all adjustments.
Most partnerships need to amend their current partnership agreements to take these changes into account and to allow partners to preserve control over decisions impacting tax liability and the audit process.
The new rules also impact the amount ultimately payable as a result of an adjustment. The partnership’s liability is determined by applying the highest effective income tax rate and, with limited exceptions, without taking into account the tax attributes of the partners. Therefore, the liability will typically be higher for the partnership than it would be if borne by the partners themselves. When the partnership makes a “push-out” election, the applicable interest rate for underpayment is 2% higher. For these reasons, the filing of amended returns by the partners will usually result in the lowest overall amount owed by the partnership and its partners, but partners themselves have no obligation to amend their returns under the law.
To further complicate matters, if the current partners are not the same as the partners in the reviewed year, the liability will be borne by different partners depending on the actions the partnership takes. This means the economic burden for an underpayment could be shifted to current partners even though they were not partners at the time an incorrect return was filed.
Instead of a tax matters partner, partnerships must appoint a “partnership representative” to represent the partnership in all tax matters, with the power to bind both the partnership and the partners by its actions. The partnership representative has a powerful role, but does not need to be a partner in the partnership. Unlike under prior law, the partners are not entitled to any notice of audit proceedings. The partners do not have the right to participate in any audit or other proceedings but must accept the outcomes.
A single exception to the consolidated audit regime applies for certain partnerships that elect out on a timely return. Review of any partnership that has elected out will be done on a partner by partner basis. This election is only available for partnerships with less than 100 partners, all of whom are “eligible.” Eligible partners are individuals, C corporations, certain foreign entities, S corporations, and estates of deceased partners. This means that partnerships in which a trust or another partnership holds an interest will not qualify to make the election. Under the Treasury Regulations, this even includes revocable and grantor trusts, as well as single-member LLCs taxed as disregarded entities, despite the fact that the separate existence of such entities is generally ignored for income tax purposes.
Most partnerships need to amend their current partnership agreements to take these changes into account and to allow partners to preserve control over decisions impacting tax liability and the audit process. The unique circumstances of a partnership will determine what changes are necessary. However, a few crucial points related to the new audit regime should be considered. Generally, partnership agreements should:
- Express the intent of the partners in light of the new law (e.g. electing out of the BBA procedures or factors to be considered in making decisions).
- Appoint a partnership representative and set out the mechanism for its removal and succession.
Require that the partners be notified of the commencement of a proceeding and remain informed regarding its status.
- Obligate the partners to cooperate in providing information to allow the partnership to make a “push-out” election or to file amended returns, where appropriate.
- Provide the desired amount of direction or discretion to the partnership representative. Some partnerships will grant the partnership representative broad discretion, which will promote administrative efficiency. On the other hand, the nature of some partnerships will make it appropriate to limit the partnership representative’s authority (e.g., by requiring a majority vote of the partners to approve certain actions). The partnership representative has sole authority with respect to the Service, but the partnership agreement can provide rules that the partnership representative must follow in exercising that authority.
- Address the recourse, if any, of the partnership or partners who pay any tax, interest, or penalties under the rules. For example, the partnership agreement may provide that such amounts are recoverable from the partner (or former partner) to which an adjustment was attributable.
Partnerships that consider these issues now will be prepared and can avoid potential snares under the BBA rules when partnership audits under the new regime for 2018 and later years begin.
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Photo by: Matthew Henry