On Nov. 2, 2015, Congress enacted the Bipartisan Budget Act of 2015 (BBA), which, among other things, repealed the complicated Tax Equity and Fiscal Responsibility Act (TEFRA) rules governing partnership audits and replaced them with a new centralized partnership audit regime that can assess and collect tax at the partnership level. This change is effective for tax years beginning after Dec. 31, 2017. Under the new rules, a partnership that is a pass-through entity could be subject to entity-level assessment. The BBA represents a broad departure from prior partnership audit procedures, under which the IRS generally was required to make adjustments and collect any additional taxes, interest, and penalties at the individual partner level.
Proposed regulations implementing the new partnership audit rules were published in January 2017. However, the proposed regulations were quickly withdrawn as part of the Trump administration’s freeze on new regulations, and it is currently unclear when the regulations will be reissued or, alternatively, if replacement regulations will be issued.
With uncertainty about when Treasury regulations will be issued and with the 2018 effective date fast approaching, partnerships and partners should begin to strategically consider how to address the anticipated effects of the new rules.
Taxpayers can select any of three regimes:
1. Default Regime: Partnership Pays. Under the new rules, the IRS can assess an entity-level tax as a result of an underpayment identified on examination. The resulting economic burden is then borne by the partners in place at the time the adjustments from the IRS examination become final, which may differ from the partners who were in place during the tax year under review.
2. Alternative Regime: Partnership Elects to Push Out Taxability to Partners. Partnerships subject to the new rules have the option to elect to pass any underpayment adjustment to reviewed-year partners, which effectively shifts the tax burden to partners who were in place during the relevant tax year.
It currently is unclear how this alternative regime applies to tiered structures and what complexities would be involved if a partnership pushes out an audit adjustment to a pass-through partner, such as a partnership or S corporation.
3. Alternative Regime: Election Out for Eligible Partnerships. Certain partnerships that issue 100 or fewer Schedule K-1 (Form 1065), “Partner’s Share of Income, Deductions, Credits, etc.,” forms may elect to opt out of the new rules completely.1 If the election is approved, the partnership is audited under the same rules that exist for individual taxpayers. Significantly, the IRS has indicated that it will closely scrutinize and take detailed notes regarding partnerships that opt out of the new audit regime.
Tax Matters Partner Eliminated
The new law replaces the tax matters partner with a partnership representative who has sole authority to act on behalf of the partnership. The partnership representative does not have to be a partner, has broad authority to represent the partnership in audits and other tax matters, and has the ability to legally bind the partnership and all partners. If a partnership does not select a representative, the IRS may select any person to be the partnership representative.
State and Local Tax Implications
While many states have federal conformity statutes in place whereby the states conform to the IRC by using federal taxable income as the starting point for the state tax calculation, the new partnership audit rules implement a procedural change that conforming states will not automatically adopt.
Some states have withholding or composite return mechanisms that allow partnerships to remit taxes to state authorities on behalf of partners. However, modification would be required in order for state taxing authorities to use existing procedures to adapt to the new federal rules. Alternatively, states may introduce new legislation adopting rules similar to the federal BBA. In addition, it is possible that some states might choose to take no action, which will create a different set of administrative and procedural complexities for taxpayers.
- U.S. generally accepted accounting principles (GAAP). Partnerships will need to evaluate and make a determination about whether a partnership-level obligation under the default regime constitutes an income tax liability of the partnership or if, instead, it is viewed as a transaction with owners for financial reporting purposes. In addition, taxpayers will need to consider possible impacts of any elections on reporting, as well as the potential impact of accounting for the change in tax law and uncertainty in income taxes on reporting and disclosure.
- Due diligence. Transactional due diligence and admission of new partners are other areas that could be indirectly affected by the new partnership audit rules. Going forward, prospective partners might wish to review entity tax records to identify potential issues that could result in a post-closing, entity-level assessment. New partners also should review closely the partnership agreement as part of due diligence to understand how the partnership is treated under the partnership audit rules and to obtain appropriate indemnifications.
Important Takeaways for Taxpayers
Partnerships and partners should begin to consider advantages and disadvantages of each alternative, and determine which audit regime is preferable. Taxpayers should consider whether a partnership is eligible to elect out of the centralized audit regime and, if so, whether the benefits of electing out outweigh potential additional scrutiny from the IRS. Partnerships that do not opt out should consider whether the default entity-level procedures are preferred or whether the partnership should elect to push out audit adjustments to partners.
Tiered partnership structures will have additional complexities to consider when evaluating the choices available, as it currently is unclear how the push-out election would apply. Taxpayers also will need to evaluate the implications of U.S. GAAP associated with the regime choice. In addition to decisions relative to the preferred audit regime, taxpayers should begin to consider who will be designated as the partnership representative, as well as appropriate duties and restrictions on the partnership representative’s authority.
Revisions to existing partnership agreements will be required in order to establish a preferred regime. Additionally, taxpayers will need to address items such as whether current and former partners will be required to reimburse the partnership for their share of any payment made at the partnership level under the default regime and the effect of audit adjustments and payment on inside and outside basis. In addition, agreements should include appropriate language about the partnership representative’s duties and restrictions on authority.
Finally, partners and partnerships should monitor activity in their relevant states closely. The specific changes and appropriate taxpayer actions will depend on each state’s response to the new federal procedures.
1 Eligible partnerships include partnerships in which each partner is an individual, a C corporation, a foreign entity that would be treated as a C corporation if domestic, an S corporation, or an estate of a deceased partner. Partnerships that have another partnership as a partner are not eligible to opt out.