United States: Say Goodbye To The TMP And Hello To The PR

Late last year, the Bipartisan Budget Act of 2015 (the "Budget Act") was signed into law. Certain provisions within the Budget Act significantly change how the IRS conducts audits of partnership and LLCs taxed as partnerships. The changes were adopted to raise revenue without increasing taxes by streamlining the IRS's partnership audit and collection processes. The new rules apply to partnership returns filed for taxable years beginning after December 31, 2017, although a partnership may elect to have the new rules apply after the date of enactment and before January 1, 2018.

The Existing Regime

Currently, the IRS audits partnerships using one of three different regimes, primarily depending upon the number of partners. For partnerships with ten or fewer partners, the IRS audits the partnership and each partner separately. Partnerships with more than ten partners are generally audited by way of a single administrative proceeding known as a "TEFRA" audit, named for the Tax Equity and Fiscal Responsibility Act of 1982. Under TEFRA, the IRS shifted the audit of partnership items from the partner to the partnership level. However, the IRS still must assess any resulting adjustment against each of the partners in the applicable tax year. Additionally, the IRS must give notice of the beginning of an audit and any resulting adjustment to all partners whose names and addresses have been furnished to the IRS and the Tax Matters Partner ("TMP")—designated by the partnership. The TMP participates in the audit on behalf of the partnership and informs the partners of the status of the TEFRA examination.

Partnerships with 100 or more partners may elect to be treated as "electing large partnerships" ("ELPs"). Although technically part of the TEFRA rules, the ELP audit regime differs in several respects. First, partnership adjustments generally flow through to current-year partners holding a partnership interest during the year in which the adjustment takes effect. The partnership may elect to pay an imputed underpayment instead of flowing an adjustment through to its partners. Even if an election is not made to pay the tax due at the partnership level, the partnership (rather than the partners) is liable for any interest or penalties resulting from the adjustment.

Under the ELP rules, a single representative must be appointed to represent the partnership in audit proceedings, and the IRS is not required to give notice of the commencement of proceedings or of a final adjustment to individual partners. Only the partnership, not the partners individually, can petition for a readjustment of partnership items.

The New Rules

The Budget Act repeals the TEFRA regime and replaces it with a regime that in some ways mirrors the ELP rules. In general, the new rules decrease the ability of individual partners to participate in the audit process and shift much of the focus to the partnership level. Among the important changes created by the new Budget Act regime are the following:

  • Like the ELP regime, the new Budget Act regime allows the IRS to collect an underpayment of tax, penalty, and interest from the partnership itself.
  • An underpayment of tax is imputed to the year during which the adjustment is finally determined. Thus, partners of the partnership in the "adjustment year" bear the tax burden of the adjustment, as opposed to partners in the "reviewed year", which is the partnership taxable year to which the item being reviewed relates. Significantly, this has the potential to expose current partners to the tax liability of past partners.
  • The tax to be paid is calculated at the highest tax rate for the reviewed year on the net income amount resulting from netting the adjustments. This is a new concept referred to as the "imputed underpayment."
  • Under the Budget Act regime, partnerships must designate a liaison with the IRS, known as the Partnership Representative. Increased powers are granted to that representative and the ability of individual partners to participate in the audit process is significantly decreased.
  • The new rules eliminate many of the notice and participation rights of individual partners.
  • The statute of limitations for partnership assessments commences when the partnership's information return is filed and no longer takes into account the date individual partners' returns are filed.

These changes raise potential issues that must be considered when drafting any partnership agreement. For example, does the agreement contain adequate indemnification provisions providing for how imputed underpayments will be paid? Does or should the agreement provide that former partners will indemnify the partnership and/or partners during the adjustment year for their share of the reviewed year liability? Should the agreement provide for withholdings from cash flow to fund future tax liabilities? Does the agreement provide a process for selecting a Partnership Representative? To whom does the Partnership Representative owe a fiduciary duty and what are those duties?

The new rules do permit a partnership to modify or avoid tax assessment and collection at the partnership level in certain situations. First, partnerships with no more than 100 partners otherwise meeting certain requirements can make an annual "opt out" election on a timely filed tax return. If a partnership opts out of the new regime, the IRS will examine the partnership and partners under the rules applicable to individual taxpayers. Second, a partnership may opt out of the "imputed underpayment" process by providing each partner in the reviewed year and the IRS with a statement of each partner's share of any adjustment. This election must be made within forty-five days of receiving a notice of final adjustment. In this scenario, "reviewed year" partners pay the additional tax on their current year individual tax returns. Finally, the amount of the "imputed underpayment" may be reduced where one or more of the "reviewed year" partners files an amended return for the reviewed year and pays the additional tax allocable to that partner.

These "opt out" provisions create additional drafting considerations. Should the agreement limit the number of partners to 100 so that the partnership may always opt out of the new regime? Should the agreement require the partnership to make the annual "opt out" election on its tax return? Should the agreement require "reviewed year" partners to file amended returns in the event of an adjustment or pay their share of the additional tax on current year returns? (Note that the filing of amended returns by "reviewed year" partners may reopen the statute of limitations on the entire return.)


These are just some of the issues raised by the new Budget Act rules that will apply to partnership audits beginning in 2018. The bottom line: All partnerships and LLCs taxed as partnerships should re-examine and amend their current agreements to ensure that the ramifications of the new rules are taken into account. Drafters of future partnership agreements should also be sure to anticipate possible consequences of federal and state partnership audits under the new regime and include appropriate provisions. Given that the new rules were enacted with the goal of increasing IRS partnership audits, it is all the more imperative that partnership agreements take the new rules into account.

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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