Audit Regulations and Investment Partnerships

By Brian J. Hecker, CPA, and Michael C. Tomchewsky, CPA
8/25/2017
For the past several decades the rate of partnership formation in terms of numbers, size, and complexity has steadily risen. This rise reflects a shift by businesses toward partnerships and away from C corporations. Because of this trend, in 2013 Congress requested that the Government Accountability Office (GAO) investigate partnerships, the rate of IRS partnership audits, and particularly large partnerships (defined as partnerships with 100 or more direct and indirect partners and $100 million or more in assets). The GAO report concluded that from 2002 to 2011 the number of large partnerships more than tripled to 10,099 (an increase of 257 percent). But as the rate of large partnerships increased, the rate of large partnership audits did not. In 2012 the audit rate for large corporations was 27.1 percent while the audit rate for large partnerships was only 0.8 percent. The GAO report concluded that the extremely low audit rate was the result of the IRS’ reluctance to apply the existing but cumbersome audit rules found in the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) to large partnerships. TEFRA has been largely criticized for being overly complex and difficult to apply in determining, assessing, and collecting taxes.1

In response, Congress enacted the Bipartisan Budget Act of 2015 (BBA) to replace the TEFRA partnership procedures with a new centralized partnership audit regime. Effective for tax years beginning after Dec. 31, 2017, the BBA makes sweeping changes to the IRS audit regime. While the TEFRA rules required the IRS to determine partnership items at the partnership level but impose liability at the partner level, the new BBA rules seek to impose liability directly at the partnership level. The new BBA rules are expected to increase the frequency of partnership audits by making audits easier for the IRS to administer and by imposing an entity-level tax directly on the partnership for any audit adjustments.

On June 14, 2017, the Department of Treasury (Treasury) re-released proposed regulations (REG-136118-15) detailing the implementation of the BBA. The re-release comes after its initial release in January 2017 subsequently was withdrawn due to newly elected President Donald Trump’s freeze on unpublished regulations. The proposed regulations provide clarity on a number of issues, including defining the requirements of the newly termed “partnership representative,” providing detailed guidance for calculating the amount of tax payable by the partnership on behalf of its partners, specifying which partnerships may opt out of the BBA rules, and devising rules for partnerships that elect to “push out” adjustments from the partnership, making the individual partners instead liable for any additional tax. It should be noted that the proposed regulations do not become law until after comments and testimony are received and final regulations are issued.

 

Significant Aspects of the Proposed Regulations

Partnership Representative

The BBA replaced the “tax matters partner” role with a new “partnership representative” role. The partnership representative does not need to be a partner in the partnership but he or she must be an individual who is authorized to act on behalf of the partnership and who has “substantial presence” in the United States. The partnership may appoint an entity as the partnership representative as long as that entity identifies an actual individual to be its representative. An individual has a substantial presence in the U.S. if he or she meets the following three criteria: 1) the person must be able to meet in person with the IRS in the United States at a reasonable time and place as is necessary and appropriate as determined by the IRS; 2) the person must have a street address in the United States and a telephone number with a United States area code at which he or she can be reached by U.S. mail and telephone during normal U.S. business hours; and 3) the person must have a U.S. taxpayer identification number (TIN). This set of criteria means that foreign partnerships that are required to file U.S. tax returns but that otherwise do not maintain a substantial U.S. presence may have to contract a U.S. agent to be their U.S. partnership representative.

Default Assessment Regime – Imputed Underpayment Calculation

If during the course of an audit the IRS determines that the partnership underreported taxable income or incorrectly allocated taxable income to a corresponding tax liability, penalty and interest is calculated at the partner level but collected at the partnership level by calculating an imputed underpayment. It’s important to note that if the liability is collected at the partnership level, the economic burden is borne by the current partners, which might not be the same as the partners in the year being audited. This scenario will be a common issue for investment partnerships whose partner base changes over time. The proposed regulations provide guidance for the calculation of the imputed underpayment, including basing the amount due at the highest federal income tax rate. Because of this guidance, it is likely that the imputed underpayment calculation initially will result in an overstatement of tax liability. The partnership representative may provide additional partner-level facts to the IRS to reduce the imputed underpayment, including identifying tax-exempt partners, foreign partners, and partners that are subject to lower tax rates (such as C corporations).

Opt-Out Election

Certain eligible partnerships may make an election out of this new regime, which would instead cause partners of those partnerships to be subject to separate audit proceedings. However, the BBA restricts the range of partnerships that are eligible to make the election to partnerships with 100 or fewer partners during the year. In addition, all the partners of the partnership must be “eligible partners.” Eligible partners include individuals, C corporations, S corporations, and estates of deceased partners. The term “eligible partner” does not include partnerships, trusts, disregarded entities, or nominees. Because the list of eligible partners is so narrow, most investment partnerships will not qualify for this opt-out election – although many general partner and management company partnerships may be eligible.  

Push-Out Election

Investment partnerships will be greatly interested in the push-out election. The centralized partnership audit regime allows partnerships to push out the liability for imputed underpayments to the persons who held an interest in the partnership during the tax year being examined (the reviewed year). A partnership that pushes out the tax liability to its partners is not liable for the tax. A partnership that chooses to push out a liability must make the election within 45 days of its receipt of a notice of final partnership adjustment (FPA). Partnerships must provide their partners and the IRS an allocation of adjusted items of gain, loss, deduction, and credit. The proposed regulations also require the partnership to calculate a safe-harbor payment amount for each partner in a manner similar to the calculation of the imputed underpayment. Partners may opt to pay this amount in lieu of recalculating the tax due on their individual returns for the years being reviewed.

Under the proposed regulations, an upper-tier partnership that is a partner in a lower-tier partnership that has made a push-out election is liable for the tax due as if the upper-tier partnership were an individual. Under the regulations the upper-tier partnership may not further push out an adjustment to its partners. Congress and Treasury are aware of public concerns and issues surrounding limiting the push-out election in multitier partnerships. The preamble to the proposed regulations states that the government is considering an approach for pushing the adjustments beyond the first-tier partners, and it will be the subject of further regulations to be published in the near future. Treasury has requested public comments on how the IRS can administer the push-out election across multitier structures to ensure the proper allocation of tax while at the same time reducing noncompliance and collection risk and limiting the administrative costs to the IRS.

Conclusion

The BBA rules go into effect in 2018, although in practice actual audits under these new rules probably won’t occur until 2020. For investment partnerships, the push-out election likely will be the preferred method of satisfying any assessed liabilities, and investors likely will demand it to ensure they are not responsible for a former partner’s liability. The comment period for the proposed regulations ended Aug. 14 and public hearings are scheduled for Sept. 18. Any further regulations addressing the push-out election in multitier structures should be of interest to investment partnerships and should be closely watched for further developments. In the meantime, offering memorandums and operating agreements should be updated to disclose the new rules and their impact on partners and name the partnership representative.


1 "Large Partnerships: With Growing Number of Partnerships, IRS Needs to Improve Audit Efficiency," U.S. Government Accountability Office, September 2014, http://www.gao.gov/products/GAO-14-732