United States: Bipartisan Budget Act Creates Changes To Partnership Audit Procedures

The Bipartisan Budget Act ("the Act"), which President Barack Obama signed into law on Nov. 2, 2015, brings about significant changes to Internal Revenue Service ("IRS") audit procedures for all entities treated as partnerships under federal tax law. The Act's new rules apply to returns filed for partnership taxable years that begin after 2017, but partnerships may elect to have the new rules apply to returns filed after the date of enactment.

Since 1982, under rules commonly referred to as "TEFRA" (because they were enacted as part of the 1982 Tax Equity and Fiscal Responsibility Act), most partnerships are audited at the entity level rather than at the partner level. (Prior to 1982, all audits were conducted at the partner level.) However, the IRS must assess and collect each partner's liability individually. The Act replaces the TEFRA rules with a regime in which both audits and adjustments to tax liability are made at the partnership level, unless a partnership is eligible and elects otherwise.

Generally, under the Act, tax adjustments (including interest and penalties) will be determined at the highest marginal tax rate, individual or corporate, in effect for the year under audit and paid by the partnership in the adjustment year. The partnership cannot deduct its payment (just as partners cannot under current law).

Thus, one major effect of the Act's new regime is that the cost of the tax adjustment is borne by those who are partners in the year of the assessment, rather than by those who were the partners in the year under audit and who benefited from the underpayment in that earlier year.

There are three ways in which a partnership can reduce the amount of the imputed underpayment it is required to pay:

  • First, the IRS may reduce the imputed underpayment amount if the partnership can show that some of the underpayment is attributable to partners in the year under audit that are not subject to tax or are subject to tax on particular types of income at rates lower than the highest rate (such as corporations with respect to ordinary income, or individuals with respect to capital gain or qualified dividends).
  • Second, the imputed underpayment amount is reduced if some or all of the partners file amended returns for the year under audit, taking into account the adjustments allocable to them, and pay the resulting tax liability. Any adjustments taken into account in the partner-level amended returns will reduce the amount used to compute the partnership-level imputed underpayment. If the adjustment would reallocate the distributive share of an item from one partner to another, this method applies only if amended returns are filed by all partners affected by the adjustment.
  • Finally, a partnership may elect to have the adjustment taken into account by all of those who were partners in the year under audit. Within 45 days after the date of the notice of the final adjustment, the partnership may issue amended Forms K-1 to its partners in the year under audit, who will then pay any additional tax due, including interest and applicable penalties, in the adjustment year.

The procedures under TEFRA do not apply to small partnerships (those with 10 or fewer partners, all of whom are U.S. citizens or resident aliens, estates, C corporations, or tax-exempt organizations), unless the partnership opts into TEFRA; instead, small partnerships are subject to the pre-TEFRA procedures. TEFRA also allows large partnerships (those with 100 or more partners) to opt out of TEFRA and have adjustments applied at the partnership level and taken into account by those who are partners in the year of the adjustment rather than the year under audit.

The Act eliminates the small partnership exception and replaces it with an opt-out election that is available to partnerships with 100 or fewer partners who are all either individuals (including foreign individuals), estates or corporations (including S corporations and foreign corporations). All of the shareholders of a partner which is an S corporation are counted toward the 100-partner limit to qualify for the opt-out. There is no longer an opt-out for large partnerships, as audits and adjustments occur at the partnership level for all partnerships under the Act.

The Act also eliminates the concept of the Tax Matters Partner ("TMP"), which has been a part of the TEFRA regime, and replaces it with the Partnership Representative ("PR"). Although both the TMP and PR generally represent the partnership in audit proceedings, there are several key differences between the two, including the following:

  • Under TEFRA, the TMP is required to provide some notices to all partners and other notices to partners designated as "notice partners." Under the Act, there are no "notice partners" and the PR has no obligation to provide any partners with notice of any proceedings.
  • Under TEFRA, the TMP does not have the power to enter into a binding settlement, or take certain other actions, on behalf of notice partners. Under the Act, the partnership and all partners are bound by the actions taken by the PR with respect to any audit or litigation proceeding.
  • Under TEFRA, the TMP must be a partner. Under the Act, the PR does not need to be a partner, but it must have a substantial presence in the U.S. This change alleviates the difficulty faced by many LLCs managed by nonmembers in identifying a member willing to serve as the TMP.

Some considerations that partnerships, and persons buying or selling partnership interests, should consider in light of the changes introduced by the Act include the following:

  • Partnerships should identify who will become the PR for partnership years beginning after 2017.
  • Many partnerships already require the TMP to give certain notices to partners; they may wish to extend/increase such requirements to the PR.
  • Partnerships may want to require the PR to obtain the approval of all or a percentage of affected partners with respect to certain actions (e.g., settlements).
  • Partners may want to require the partnership to make certain elections in the event of an audit adjustment (for example, requiring the PR to make a timely election to have the partnership adjustment taken into account by the partners in the year under audit).
  • Partnerships may want to provide that the economic burden of the tax will be distributed in an equitable manner among the partners to take into account, for example, amended returns filed by certain partners for the audit year or any reduction in the partnership underpayment as a result of the tax status of certain partners, thereby reducing the imputed underpayment required to be paid by the partnership.
  • Given that, absent an election to the contrary, the cost of the adjustment will economically be borne by partners in the adjustment year, and not the audit year, in order to address the potential adverse consequences of the burden shifting, persons purchasing partnership interests from existing partners should consider (i) conducting additional diligence regarding past returns, (ii) obtaining indemnities from the selling partners, (iii) requiring the selling partners to file amended returns in the event of an underpayment, and/or (iv) requiring the partnership to elect to have the adjustment taken into account by those who were partners in the year under audit.

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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