In addition to the discussion of the new partnership audit rules, this month's issue features articles regarding a recent district court decision in Ellis v. United States regarding the attorney-client privilege and work product protections, amendments to the Federal Rules of Civil Procedure, recent developments concerning the IRS' enforcement efforts regarding offshore accounts and a discussion of the benefits and potential pitfalls of making a tax deposit.
New Partnership Audit Procedures May Dramatically Affect the Assessment and Collection of Taxes Relating to Partnership Activities
The Bipartisan Budget Act of 2015 (the "BBA"), which was signed into law in November 2015, includes sweeping changes to the rules governing federal tax audits of entities treated as partnerships for US federal income tax purposes. The new rules replace the long-standing regimes for auditing partnerships under the Tax Equity and Fiscal Responsibility Act of 1982 ("TEFRA") and the Electing Large Partnership ("ELP") rules. The new rules allow the Internal Revenue Service (the "IRS") to deal with only a single "partnership representative," similar to the tax matters partner under TEFRA, during an audit and any related court cases. Unless a partnership elects out, the new rules impose an entity-level tax on the partnership at the highest rate of tax in effect for the reviewed year (subject to potential reduction) for any understatements of partnership income. The entity-level tax can be avoided, however, if the partnership elects to "push out" the adjustment to its partners by providing them with adjusted Schedule K-1s reporting their allocable share of any partnership-level audit adjustments. The purpose of the new rules is to streamline partnership audits under a single set of rules and to make it easier for the IRS to assess and collect tax after a partnership audit. Importantly, the new audit regime will apply only to partnership tax returns filed for taxable years beginning after December 31, 2017 unless a partnership elects to apply them to an earlier taxable year. The BBA contains profound changes affecting both partnerships and partners. Consequently, a review of partnership agreements to analyze how these rules will affect existing partnerships is advisable.
Background
The TEFRA regime, which generally remains in place until the BBA's audit provisions become effective, provides for unified audit procedures to determine the tax treatment of all "partnership items" at the partnership level, after which the IRS can assess each audited-year partner individually based on the partner's allocated share of the adjustments. The TEFRA rules also include procedures for notice to, and participation by, partners in audits and any related litigation. The BBA audit provisions will replace both the TEFRA regime as well as the rarely-used tax provisions and audit procedures for ELPs (electing partnerships with more than 100 partners). Partnerships that elected to be treated as an ELP were subject to a unified audit under which any adjustments were generally reflected on the partners' current year return rather than on an amended prior-year return. The ELP rules were adopted to make audits of large partnerships less burdensome. But most large partnerships did not elect ELP treatment, and the IRS found the ELP regime to be underutilized. Under the BBA's audit provisions, partnerships with more than 100 partners will be governed by the new rules as no election to opt-out is permitted.
Application of the New Partnership Audit Procedures
All partnerships will be subject to the new audit procedures provided for in the BBA unless they are permitted to elect out. Thus, partnerships with as few as two individuals will be covered by default under the BBA. Partnerships with more than 100 partners may not elect out of the BBA provisions.
A partnership with 100 or fewer partners can elect out of the new rules for a taxable year if all of its partners are individuals, C corporations (including entities treated for tax purposes as real estate investment trusts or regulated investment companies), foreign entities that would be treated as C corporations if they were domestic, or estates of deceased partners. A partnership with an S corporation partner may elect out of the new rules if all of the S corporation’s shareholders are identified 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. Partnerships with other types of partners, such as partnerships, trusts, or certain tax-exempt entities, cannot elect out of the new audit procedures. Accordingly, tiered partnerships cannot elect out of the BBA audit procedures.
To elect out of the new rules with respect to a taxable year, a partnership must:
- include the election with its timely-filed income tax return for that year;
- disclose the names of all of its partners and their tax identification numbers to the IRS; and
- provide its partners with notice of the election.
If a partnership with 100 or fewer partners elects out of the new rules, the general non-partnership assessment and collection rules will apply. As a result, partners in a partnership, where the partnership has filed the partnership return and disclosed the election out of the BBA, may take inconsistent positions regarding partnership items reported on their Schedule K-1s, without providing notice to the IRS of the inconsistent position. In the case of a partnership that elects out of the BBA, the IRS still may audit the partnership, but it must make all tax adjustments at the partner level (i.e., the partnership cannot settle issues on behalf of partners), and the partnership cannot extend the statute of limitations for the partners. Accordingly, in such a case, the IRS would need to timely issue 30-day letters or notices of deficiency to the individual partners.
While the ability to elect out of the new partnership audit regime may be useful in certain cases (such as closely held partnerships among sophisticated partners), the elect-out provisions may be of limited utility because, as a practical matter, most investment funds and widely-held partnerships are unlikely to satisfy the requirements for electing out.
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