On November 2, 2015, President Barack Obama signed the Bipartisan Budget Act of 2015 (the Act) into law, instituting for tax years commencing after 2017 significant changes to the rules governing federal tax audits of entities that are treated as partnerships for U.S. federal income tax purposes. The new rules impose an entity-level liability for taxes on partnerships (and concomitantly, in the case of a general or limited partnership, the general partner) in respect of Internal Revenue Service (IRS) audit adjustments, absent election of an alternative regime described below under which the tax liability is imposed at the partner level. The new rules constitute a significant change from existing law and will require clarification through guidance from the U.S. Department of the Treasury (Treasury).
Certain small partnerships are eligible to elect out of the provisions altogether for a given taxable year, with the result that any adjustments to such a partnership’s items can be made only at the partner level. This election may be made only by partnerships with 100 or fewer partners, each of which is an individual, a C corporation, an S corporation or an estate of a deceased partner. Accordingly, for example, any partnership having another partnership as a partner is not eligible to elect out of the new audit regime.
Under the new rules, in general, audit adjustment to items of partnership income, gain, loss, deduction or credit, and any partner’s distributive share thereof, are determined at the partnership level. Subject to election of the alternative regime discussed below, the associated « imputed underpayment”—the tax deficiency arising from a partnership-level adjustment with respect to a partnership tax year (a reviewed year)—is calculated using the maximum statutory income tax rate and is assessed against and collected from the partnership in the year that such audit or any judicial review is completed (the adjustment year). In addition, the partnership is directly liable for any related penalties and interest, calculated as if the partnership had been originally liable for the tax in the audited year.
The Act directs the Treasury to establish procedures under which the amount of the imputed underpayment may be modified in certain circumstances. If one or more partners file tax returns for the reviewed year that take the audit adjustments into account and pay the associated taxes the imputed underpayment amount should be determined without regard to the portion of the adjustments so taken into account. If the partnership demonstrates that a portion of the imputed underpayment is allocable to a partner that would not owe tax by reason of its status as a tax-exempt entity the procedures are to provide that the imputed underpayment is to be determined without regard to that portion. The Act also directs that these procedures take into account reduced corporate, capital gain and qualified dividend rates as to the portion of any imputed underpayment allocable to a partner to which pertinent.
Under an alternative regime, if the partnership makes a timely election with respect to an imputed underpayment (a push-out election) and furnishes to each partner of the partnership for the reviewed year, and to the Treasury, a statement of the partner’s share of any adjustment to income, gain, loss, deduction or credit, the rules requiring partnership level assessment will not apply with respect to the underpayment and each affected partner will be required to take the adjustment into account on the partner’s individual tax return, and pay an increased tax, for the taxable year in which the partner receives the adjusted information return. Under this alternative, the reviewed year partners (rather than the partnership) are liable for any related penalties and interest, with deficiency interest calculated at an increased rate and running from the reviewed year.
The Act also institutes significant changes to procedural aspects of partnership audits. Among other things, the “tax matters partner” role under prior law is replaced with an expanded “partnership representative” role. The partnership representative, which is not required to be a partner, will have sole authority to act on behalf of the partnership in an audit proceeding, and will bind both the partnership and the partners by its actions in the audit. The IRS no longer will be required to notify partners of partnership audit proceedings or adjustments, and partners will be bound by determinations made at the partnership level. It appears that partners neither will have rights to participate in partnership audits or related judicial proceedings, nor standing to bring a judicial action if the partnership representative does not challenge an assessment. Partnerships challenging an assessment in a district court or the U.S. Court of Federal Claims will be required to deposit the entire amount of the partnership’s imputed liability (in contrast to existing rules that only require a deposit of the petitioning partner’s liability). Also, the statute of limitations for adjustments will be calculated solely with reference to the date the partnership filed its return.
As noted, the Act’s new partnership audit regime applies to tax returns filed for partnership taxable years beginning after December 31, 2017. The delayed effective date affords taxpayers time to consider the potential effects of the new rules on entities taxed as partnerships and their operative agreements and to evaluate options for addressing them. While the Act provides that a partnership may opt for the Act’s amendments to the partnership audit rules to apply to any return of the partnership filed for taxable years beginning after the date of enactment of the Act, it is unlikely many partnerships will make such an election, at a minimum until such time as much needed Treasury guidance is produced.
Among the questions left unanswered for the moment are these:
Are the elections such as the push-out election self-executing, or is there a need for an issuance of regulations for such elections to be effective?
Will the ability to elect out of these new rules under the small partnership exception be available if a partnership has among its members a single-member limited liability company or a grantor trust?
In the absence of a push-out election (and assuming the small partnership exemption is unavailable):
How do adjustments to income/deduction flow out to partners?
Since the associated tax will have been paid by the partnership already, by what mechanism do the partners avoid paying tax on the same income at the partner level?
How do these rules work with items allocated by a partnership that are determined at the partner level?
If there is an item of income flowing from an IRS adjustment to the partners, do the partners increase their outside basis in their partnership interests to reflect their shares of the income?
How does the IRS prevent gamesmanship in instances where there are significant shifts in partnership interests between the reviewed year and the adjustment year?
How are the rules intended to work in the case of a constructive partnership? What if the constructive tax partnership does not constitute a state law partnership? Since there is no juridical entity, is nobody liable for the taxes flowing from the IRS adjustments? If the constructive partnership is a state law partnership (and therefore a general partnership) is each partner liable for the totality of the tax? Can a push-out election be made on a protective basis (i.e., without conceding to the existence of a partnership) in order to avoid such an outcome? Who would make it?
Are partners ultimately liable under any circumstances for adjustments, where the partnership is insolvent or otherwise cannot satisfy the adjustments (for example, under transferee liability principles)?
What will be the state income tax consequences of federal audit adjustments?
If a push out election is made:
Can partners take their loss carryovers and other tax attributes into account in calculating the associated tax?
What happens if one or more partners do not pay the associated tax? Does the partnership have a residual exposure?
As to the appointment of a partnership representative:
Is it possible to replace a partnership representative once an audit has commenced?
If the IRS appoints a partnership representative, does the appointee need to have some connection to the partnership?
Presumably appointees by the IRS can refuse the appointment; what can we expect to be the IRS’ backup plan?
Potential Contractual Provisions to Take the New Rules into Account
Set forth below are suggestions for the inclusion of provisions in partnership agreements in light of the new law. No single set of provisions can fit all circumstances, and, of course, the desirability of some of these provisions will depend on the partner’s frame of reference; the partnership representative is going to have different objectives than is a minority partner, for example. Possible contractual provisions include the following:
Use the small partnership exception, if available, and notify all partners of its election.
Consider restricting eligible new partners to those that do not undercut the availability of this exception.
Consider prohibiting transfers that would terminate eligibility for the exception.
If the small partnership exception is not available, require the push-out election, and place contractual obligations on partners related thereto. Require partners to execute an acknowledgement and agreement that sets forth the import of the election.
In the absence of a small partnership exception or push-out election, agree on the economic sharing of partnership-level tax payments. For example:
Provide that partnership-level tax payments in an adjustment year will be economically borne in proportion to the partners’ income in the reviewed year, taking into account characteristics of a partner that reduce the payment.
State whether partners’ shares of tax payments will be collected from them by current payment or by offset against distributions.
Provide that departed or reduced interest partners agree to make payments for their shares of tax payments that cannot be offset against distributions.
Permit a holdback of distributions in the event of pending or expected tax audits.
Provide for the allocation of tax amounts that cannot be recovered from departed or reduced interest partners.
Provide that the existing governance mechanisms of the partnership (whether managing partner or member, management committee or board) control tax decisions and the appointment, replacement and direction of the partnership representative. Authorize or require the partnership representative, acting at the direction of the board or other governing authority, to do some or all of the following:
Notify all partners upon the commencement of an IRS audit.
Inform partners of the progress of the audit and consult with the partners before taking positions in response to proposed adjustments.
Resolve IRS audits in its sole discretion. Alternatively, condition authority on a certain level of partner consent and exonerate the partnership representative and the board from liability if the partnership representative proceeds on the basis of such consent.
Require partners to provide the partnership representative timely partner-level information to mitigate partnership level tax.
Secure partners’ agreement to file amended returns at the partnership representative’s request.
Make all elections and other decisions called for under the new rules in the exercise of its sole discretion. Alternatively, require the partnership representative to seek authorization for each such decision and action before taking it (perhaps on the basis of majority rule).
As the foregoing list demonstrates, it is not too early for affected taxpayers to start turning their attention to the practical steps they should be considering to address the implications of the new rules. Certainly, drafters of new partnership agreements and LLC operating agreements should consider including provisions such as those identified above. Moreover, a determination will need to be made as to whether existing partnership and LLC operating agreements should be amended in light of the new rules and, if so, how and with what implications (for example, in terms of required consents). In the context of mergers and acquisitions, potential purchasers of partnership interests are likely to require that the partnership commit to make the push-out election in the event of an audit. In short, the new partnership audit rules were enacted into law with little fanfare, and seemingly in short order, but with considerable consequences to the business community for years to come.