United States: Important New Audit Rules Change Taxation Of Partnerships

On November 2, 2015, the Bipartisan Budget Act of 2015 (BBA) became law. Buried in the BBA are new rules replacing the long-standing Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) and the Electing Large Partnership rules that previously governed partnership audits. These new rules turn established partnership tax law on its head.

Under BBA rules, if a partnership understates its income or overstates its deductions, it is subject to income tax. Not only can the partnership owe income tax, the tax will not be based on the income for the year in question, but instead on one or more prior years' income. Consequently, the economic burden of the tax could be borne by partners who had no interest in the partnership when the income was generated. Conversely, if a partnership overstated its income in a prior year, the benefit of correcting that overstatement will accrue to the current partners, not those who were partners in the earlier year. Finally, if a partnership elects out of the new provisions (assuming it is eligible), the IRS will no longer be able to conduct a centralized audit controlling each partner's distributive share, but will instead have to audit each partner individually.

The BBA rules apply to partnership returns filed after 2017, although a partnership may elect to have these rules apply to returns filed before 2018. Not only will these new rules vastly complicate the audit of partnerships that elect out, but they will also require that virtually every partnership in existence consider electing out or revising its partnership agreement to address BBA.

Who is subject to BBA?

All partnerships are subject to the new rules unless they elect out. Although TEFRA excluded partnerships with 10 or fewer partners who are individuals (excluding NRAs), C corporations or estates, BBA has no such automatic exception. As a result, all partnerships are now covered: even those with as few as two individuals, family limited partnerships, LLCs treated as partnerships for tax purposes, and tiered partnerships. The only excluded partnerships are those that are eligible to elect out and do so on a timely basis.

What does BBA do?

BBA is similar to TEFRA in many respects. Like TEFRA, it requires that all items of income, loss, deduction or credit be determined at the partnership level. Like TEFRA, BBA provides that a partner's tax return must be consistent with the K-1 the partnership issued, unless the partner files a notice of inconsistent treatment. If a partner fails to file the notice, the IRS may treat any underpayment of tax resulting from the inconsistent position as a mere mathematical or clerical error and assess the tax without issuing a deficiency notice.

Like the Tax Matters Partner under TEFRA, BBA's "Partnership Representative" (who does not have to be a partner) is the point of contact for the IRS and can bind the partnership. Unlike TEFRA, however, BBA provides that all tax attributable to adjustments (called the "imputed underpayment") is assessed in the current year against and collected from the partnership, along with interest (determined from the due dates for the reviewed years) and penalties. Also unlike TEFRA, BBA provides that penalties are exclusively determined at the partnership level; there is no partner-level defense.

How does BBA calculate an imputed underpayment?

Under BBA the years audited are called the "reviewed years," and the year in which an audit becomes final is called the "adjustment year." The imputed underpayment is determined by adding together or "netting" all adjustments to items of income, gain, loss and deduction and multiplying the result by the highest tax rate in effect for the reviewed years under section 1 (individuals) or section 11 (corporations).

The imputed underpayment is calculated without regard to the nature of the adjustments; all positive or negative adjustments to capital gains, losses, whether long or short term, items of ordinary income or other types of income or loss, are netted. Nor does it appear to matter that items might be subject to restrictions on deduction at the partner level such as the "at risk" or "passive activity" limitations. If the audit adjusts tax credits, those adjustments are taken into account.

Reallocations in partners' distributive shares are treated differently and are not netted. For example, if an audit reallocates income from one partner to another, BBA counts only the increase in income, not the decrease, and adds the increase to the partnership underpayment. This treatment will result in phantom income and tax to the partnership even though it does not change the net income reported on the Form 1065.

What if there would be less tax if the adjustments flowed through to the partners?

In many circumstances, the imputed underpayment will be less overall if the adjustments flowed through to the partners. For example, a partner might have a net operating loss that could absorb an adjustment. BBA provides that Treasury shall issue rules allowing partners to elect to file amended returns for the reviewed years (i.e., the audited years). If the amended returns take into account all adjustments made, and if the tax is paid, then those adjustments will be removed from the partnership level adjustment. Reallocations of distributive shares will be removed only if all the partners affected file amended returns. Treasury will also issue rules to reduce the partnership level tax rate without requiring amended returns from the partners in certain situations, such as where there are tax-exempt partners. A similar rule will apply lower tax rates if the adjustment includes ordinary income to a C corporation partner (which would pay a lower tax than an individual partner would) or if the adjustment includes capital gain or qualified dividends to an individual partner. Finally, Treasury may issue regulations that make other modifications to the imputed underpayment in similar circumstances. A partnership seeking to reduce its imputed underpayment under this provision must supply supporting documentation to the IRS within 270 days of issuance of a Proposed Partnership Adjustment.

Can a partnership elect to make the partners liable for the adjustments?

A partnership may elect to have the adjustments shown in a Final Partnership Adjustment (FPA) flow through to its partners. The partners' tax for the year of the election will be increased by the amount their tax in the reviewed years would have increased based on their distributive share of the adjustments made. In addition, the tax will include any tax that would have resulted from those adjustments in the years after the reviewed year and before the election year. All tax attributes, such as basis, will be affected by these adjustments.

The partnership must elect this flow-through within 45 days of issuance of the FPA. If it makes the election, the partnership will not be liable for any tax. Although the statute is unclear, it appears that the partnership can still contest the FPA in court.

The effect of this election is similar to a TEFRA adjustment, but instead of actually imposing tax in the earlier years, it imposes a tax in the year of the election. In addition to the tax, partners will liable for any penalties and interest, but the interest rate is increased by two percentage points and runs from the earlier years that generated the liability.

What if an audit reduces the tax reported?

If a partnership audit reduces the income originally reported or increases the net loss originally reported, these changes will constitute adjustments for the adjustment year (audit year) and will flow through to the partners for that year.

As under TEFRA, partnerships that have over reported their income may file an Administrative Adjustment Request (AAR), but the IRS will treat any decrease in income or increase in loss as occurring in the year the AAR is filed. If the partnership determines it underpaid its tax, it may file an AAR, but payment of tax is due on filing.

TEFRA provided that the Tax Matters Partner could file an AAR on behalf of the partnership or that any other partner could file an AAR on its own behalf. However, under BBA, only the partnership can file an AAR; a partner no longer may file its own AAR.

Who can elect out?

Partnerships with 100 or fewer partners can elect out, if the partners are all individuals (including NRAs), C corporations, foreign entities that would be treated as C corporations if they were domestic, or estates of deceased partners. An S corporation also may qualify, if it identifies all of its shareholders to the IRS. In that event, each of the S corporation's shareholders counts as a partner for purposes of the "100 or fewer partners" test. A partnership that has even one partner that is itself a partnership cannot elect out, nor does it appear that a partnership could elect out if it has a trust as partner. Although TEFRA contained a provision that a husband and wife counted as one partner for the similar "10 or fewer" rule, BBA contains no such exception.

How does a partnership elect out?

An election applies to one year only and must be made in a timely filed return for that year. The partnership must identify all the partners to the IRS and give the partners notice of the election.

What happens if a partnership elects out?

If a partnership elects out of BBA, the consistency provisions no longer apply. As a result, each partner may take an inconsistent position regarding partnership items reported on its K-1, without providing notice to the IRS of the inconsistent position.

If a partnership elects out, the IRS still could audit the partnership, but it must make all tax adjustments at the partner level. Accordingly, it would have to issue 30-day letters or notices of deficiency to the individual partners. We expect many partnerships that were subject to TEFRA will elect out of BBA, which will put the IRS in a bind. If the IRS issues a taxpayer a notice of deficiency and the taxpayer petitions the Tax Court, the IRS ordinarily is barred from issuing another deficiency notice if it later discovers additional adjustments. Accordingly, if a partnership elects out of BBA and the IRS makes adjustments on audit, it will have to decide whether to fully audit the returns of the partners (significantly increasing the IRS' workload) or issue notices of deficiency and thereby risk losing the opportunity to make further adjustments to those returns.

What are the procedural rules for audits?

The procedural rules are similar to TEFRA. The IRS must give notice of the beginning of the audit. The IRS, however, is required to give notice of any Proposed Partnership Adjustment and then must wait at least 270 days before issuing a FPA. The 270 days gives the partnership time to produce documentation supporting lower tax rates for an imputed underpayment. The IRS must wait 90 days after issuing the FPA before assessing, and-if the partnership timely petitions in court-the IRS must wait until the decision is final to assess. Petitions in Tax Court do not require pre-payment, but a partnership filing in district court or the Claims Court must pay the estimated imputed underpayment. There are, however, a number of procedural differences between BBA and TEFRA. For example, BBA requires that the IRS issue a Proposed Partnership Adjustment, which has legal consequences, whereas TEFRA did not require that an analogous 60-day letter be issued. TEFRA also provided that any partner could participate in the audit and many could bring suit, whereas BBA provides that only the partnership may take those actions.

Finally, TEFRA provided that if an AAR is filed and the IRS did not act on it, the taxpayers could bring a suit in court, whereas BBA provides for such suit only if the IRS issues an FPA, apparently leaving taxpayers without remedy.

Statute of limitations

BBA provides that an adjustment generally must be made (presumably "assessed") within 3 years from the later of (1) the date the partnership return for the reviewed year was filed, (2) the due date for that return, or (3) the date the partnership filed an AAR for the year. However, if the partnership timely submitted documentation to support a reduced tax rate, the adjustment may also be made within 270 days of the date all such documentation was submitted, plus any extensions of time given to submit. Finally, even if the partnership did not request a reduced tax rate, an adjustment also will be timely if made within 270 days of the date a Proposed Partnership Adjustment was issued. An adjustment made within any of these periods is timely, and the partnership can extend the time to make the adjustment. The periods also are extended in other situations. If the amount of unreported income exceeds 25 percent of the gross income of the partnership for the reviewed year, the IRS has 6 years to make the adjustment. Moreover, if the partnership did not file a return or filed a fraudulent return, there is no limitation.

Will there be guidance?

The BBA rules make fundamental changes in the tax treatment of partnerships and raise a multitude of new questions. Treasury has been directed to issue regulations, and the IRS is expected to issue additional guidance. Nevertheless, the rules undoubtedly will result in much confusion and litigation in the coming years.

What should partnerships do now?

The BBA raises a number of issues that taxpayers should consider. Among them is whether partnership agreements need to be revised to address the BBA. Some partnerships, for example, might consider provisions that require electing out of the BBA (if that is possible). Under the BBA, the economic consequences of a tax audit of a given year or years will accrue in a subsequent year when the partnership might have different partners. Taxpayers might consider provisions addressing such possibilities and providing for appropriate tax sharing or allocation provisions. In any event, taxpayers using partnerships for businesses or investments and persons buying or selling partnership interests need to be aware of these provisions and should consult with their tax advisors.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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