United States: Dramatic Changes To Partnership Audit Rules Will Require Advance Planning And Changes To Partnership Documents

The recent passing of Bipartisan Budget Act of 2015 (the "Act") includes dramatic changes to the rules governing federal tax audits of limited liability companies (LLCs) and other entities treated as partnerships for federal income tax purposes. These changes aim to increase the number of partnership tax audits by making it easier for the IRS both to conduct the audits, and to collect assessed balances due. Unless a partnership elects to apply them sooner, the new rules will apply to tax years beginning after December 31, 2017.

In the meantime, LLCs and partnerships need to be aware of the changes and begin to take steps to respond to them.

Today's Rules

Currently, there are three possible sets of rules for auditing partnerships. The most common is the "TEFRA" rules. Under the TEFRA rules, although the treatment of partnership items is determined at the entity level, the IRS assesses the partners individually for any balance due, based on the partner's share of the adjustment. The partners affected are those who were partners in the tax year being audited.

In addition, partnerships with over 100 partners can elect to be use simplified audit rules, under which partnership-level adjustments flow to those who are partners when the adjustment occurs, as opposed to partners in the tax year being audited. Very few large partnerships elect to use these simplified rules.

Finally, for certain small partnerships, adjustments are determined in separate proceedings for each partner under generally applicable audit procedures.

Changes Ahead

The Act repeals the existing partnership tax audit rules, and replaces them with an entirely new set of rules. Major changes include the following:

  • All partnerships will be audited at the partnership level only, and not at the individual level.
  • If an adjustment is made resulting in additional tax, instead of assessing liability against the partners, the tax is assessed on the partnership itself. By default, this entity-level tax is imposed in the year when the adjustment is being made, and not carried back to the tax year under audit. Unless certain exceptions apply, the tax is generally determined using the highest tax rate in effect for the tax year under audit, regardless of the character of the underlying income or the tax status of the partners. Under these rules, partners in the tax year in which the adjustments are being made will bear the cost of the adjustments, even if the adjustments relate to a tax year in which they were not a partner.
  • As an alternative to the partnership paying the tax from audit adjustments, partnerships can elect to have the partners in the tax year under audit pay the tax instead, at the cost of a higher rate of interest. If that election is made, each partner would reflect the adjustment on their tax return for the year when the adjustment is made (not the tax year under audit).
  • Instead of a "tax matters partner," each partnership must designate a "partnership representative." This representative is not required to be a partner, but must have a substantial presence in the United States. The partnership representative has sole authority to act on behalf of the partnership in an audit proceeding.
  • The statute of limitations will be applied solely with respect to the partnership's tax return.

Election Out for Some Small Partnerships

Certain small partnerships (those required to furnish 100 or fewer Schedule K-1s) can elect out of the new rules. However, this election is only available if each partner of the partnership is an individual, C corporation, certain foreign entities treated as C corporations, an S corporation, or an estate of a deceased partner. As enacted, this election would not be available if one of the partners is itself a partnership. For example, an LLC owned by an investment fund would not be able to elect out of the new rules. As enacted, this election must be made every year.

Expected Guidance and Practical Implications

The new partnership audit rules represent a dramatic change from existing law and will likely have a significant impact on many aspects of partnership transactions. Many of the details of these rules are reserved for future guidance from the IRS. Additionally, there may be technical corrections to certain aspects of these rules. We will be studying these developments very carefully, and will keep you informed.

Although the rules will generally not take effect until 2018 for most partnerships, LLCs and other partnerships should take steps ahead of time to prepare for potential audits under the new rules. Specifically:

  • Existing LLC operating agreements and partnership agreements should be reviewed and potentially revised in light of these new rules.
  • Purchasers of partnership interests will need to be aware of the increased risk from audits of tax years prior to the acquisition and obtain appropriate indemnities from sellers.
  • Disclosures regarding these new rules should be added to offering documents for investment funds.
  • Once these rules take effect, there will likely be an increase in audit activity involving partnerships, which historically have been audited much less frequently than C corporations.

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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