The new rules are generally effective for partnership tax years beginning after December 31, 2017, but partnerships may elect to be governed by the new audit rules for any tax year beginning on or after November 2, 2015, and before January 1, 2018
Key Changes Under the New Rules
- The IRS is no longer required to look to partners of a partnership in order to collect tax deficiencies imposed as a result of a partnership audit. In the case of partnerships with many partners and complex holdings, the IRS previously had to determine the partnership level adjustment and then calculate the resulting tax liability of each partner for the particular audit year, making it difficult for the IRS to audit partnerships. The new rules permit the IRS to assess and collect, at the partnership level, any underpayment of U.S. federal income tax (including penalties and interest) that is owed by the partners as a result of a partnership audit.
- Unless a partnership opts out of the new rules, any persons who are partners at the time an audit is completed will bear the cost of any underpayment imposed by the IRS on the partnership, instead of the partners who benefitted from the underpayment of tax in the earlier year being audited.
- A partnership would be required to pay, in the year the IRS makes the adjustment, any "imputed underpayment" with respect to any assessment, determined by netting all adjustments to items of income, gain, loss, or deduction and multiplying that net amount by the highest tax rate applicable to an individual.
- The imputed underpayment may be reduced based on partner-level characteristics (for example, if a partner is tax-exempt or otherwise subject to a lower tax rate), and it may also be reduced to the extent that one or more partners file amended returns to take into account all of the portion of the adjustment properly allocable to such partners, and pay any taxes due on such amended returns.
- A partnership can opt out of the new rules only if it has 100 or fewer partners, and each of the partners is an individual, an estate, a C corporation, an S corporation, or a foreign entity that would be treated as a C corporation under U.S. law. A partnership with an S corporation as a partner has additional information obligations in connection with the opt-out election. The new rules do not permit a partnership to opt out if it has a partner that is itself a partnership and, therefore, the ability to opt out of the new rules may not be available for most private investment funds (e.g., the fund general partner itself is typically a tax partnership).
- A partnership can make an election under new Section 6226 (Push Out Election), within 45 days after the audit is finalized, to shift a tax liability adjustment to the persons who were partners during the year(s) to which the adjustment relates. If the election is made, the individual partners affected would have to take the adjustment into account and pay additional tax for the current year based on the taxes that would have been due for prior years as a result of the adjustment, along with any penalties that may be due and interest at a rate that is two percentage points higher than the normal interest rate applicable to tax underpayments.
- The Push Out Election applies only to partners whose tax liabilities increase as a result of a partnership audit — if a partner's tax liability decreases by reason of the adjustment, that decrease is treated as a reduction of partnership income for the year the audit is finalized instead of providing a potential refund to those who were partners during the taxable year under review. It is unclear how the Push Out Election would apply to upper-tier partnerships (or other pass-through entities) that are partners in the partnership under audit. If the Push-Out Election causes an upper-tier pass-through entity to bear the tax, a fund may prefer to make the election, even though it could benefit tax-exempt investors.
- The concept of a "tax matters partner" has been replaced with a "partnership representative," who will have broad authority to act on behalf of the partnership in connection with audits or judicial proceedings, and who no longer has to be a partner of the partnership. With this change, funds are now allowed to designate a management company or investment advisor to serve as "partnership representative."
- Partners no longer have the right to participate in, or receive notices relating to, any U.S. federal income tax audits of the partnership unless those rights are contractually negotiated with the fund (e.g., via a side letter).
Steps That Should Be Taken
In view of the new rules, both fund sponsors of, and investors in, private investment funds should consider amending (or causing the sponsor to amend) the audit provisions in existing fund agreements to address some or all of the following issues:
- Allocating any taxes, penalties, and interest arising from an audit solely to those taxable investors of the fund who were partners in the year under audit
- Requiring an opt-out election, if it is available
- Requiring the fund to make the Push Out Election
- Providing fund partners with information and notice rights relating to tax audits
- Requiring investor consent to the selection or modification of the fund's partnership representative
- Requiring investor consent before the fund's partnership representative can bind the partnership in an audit proceeding, litigation, or settlement relating to the partnership's federal income tax liability
- Obligating the general partner to attempt to reduce the imputed underpayment by proving applicable modifications, such as lower applicable tax rates or the existence of tax-exempt or non-U.S. partners
- Taking into account the partnership tax burden on the economics of the fund, including the tax distribution (and deemed distribution) provisions and general partner clawbacks
- Detailing a mechanism for the fund to recover from the partnership's imputed underpayment from the partners, such as with offsets from payments that would otherwise be distributed to the partners
- Providing for indemnification of continuing partners in the event of the fund's complete redemption of a partner's interest
- Addressing the rights and protections of a selling partner in the event of a subsequent audit of partnership items relating to a period during which the seller was a partner
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