Every business in partnership form is affected by the recent signing[1] of the Bipartisan Budget Act of 2015 (the “Budget Act”) and should re-examine the tax provisions of its partnership agreements.
Within the Budget Act is a complete overhaul of the partnership audit procedures of the Internal
Revenue Service (IRS) for all entities treated as partnerships, effectively repealing the audit procedures of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) and the Electing Large Partnership rules. These changes are intended to resolve administrative difficulties created by the current partnership audit procedures, increase audit frequency, and raise nearly $10 billion in additional revenue over the next decade.[2]
These changes will render most existing partnership agreements inadequate to address possible
future audits. In effect, the new audit procedures levy audit adjustments at the partnership level, rather than at the partner level. For partnerships and their past, present, and future partners, these changes present a host of new issues that current partnership agreements were not designed to address.
Partnerships will be subject to these new audit procedures effective with tax years beginning on or
after January 1, 2018, but now is the time to re-examine partnership agreements and make any necessary revisions in preparation. In particular, partnerships will want to consider who (present or past partners) will bear the cost of an audit adjustment, whether the tax position of a partner will influence the division of liability among those classes of partners, and whether opting out of the new audit procedures might be appropriate. Careful analysis and planning can ensure that partnerships and
individual partners are prepared when these new audit procedures go into effect.
Current Partnership Audit Procedures
Under current law, the IRS uses three distinct regimes for auditing partnerships, depending upon
the number of partners and whether the partnership has elected to be treated as an Electing Large Partnership. The existing procedures have made it relatively difficult for the IRS to audit partnerships, resulting in low audit rates. A 2014 report from the Government Accountability Office found that the IRS’s audit rate of partnerships with $100 million or more in assets for the 2012 fiscal year was 0.8 percent, as compared to an audit rate of 27.1 percent for C corporations of the same size.[3] Much of the administrative difficulty of auditing partnerships arises because the IRS generally performs audits at the partnership level but then must make tax adjustments, and collect any additional taxes, interest, and penalties, at the partner level.
New Partnership Audit Procedures
Starting with tax years that begin on or after January 1, 2018, the IRS will implement audit procedures that apply to all partnerships, except for those partnerships that are eligible to opt out and choose to do so (discussed in more detail below).[4] Under the default audit procedures, tax adjustments resulting from an IRS audit of a partnership will be determined and collected at the partnership level, rather than at the partner level. This is despite the long-established principle that partnerships are not subject to income taxes, and that the incidence of taxation falls on partners.
For those partnerships that do not opt out of the default audit procedures, the IRS would first audit the partnership, reviewing its reported income, gain, loss, deduction, and credit for a specific year. If the audit prompted an adjustment, any underpayment would be paid by the partnership, rather than the partners, in the year that the underpayment is determined. In other words, any underpayment would need to be satisfied by the partnership’s own assets or with contributions from its partners at the time of the adjustment, rather than the prior year under audit. The default procedures do not impose joint and several liability on partners for liabilities determined at the partnership level. However, the cost of an audit adjustment would effectively be borne by the partners at the time the IRS makes the adjustment, regardless of whether those persons were partners (or had any interest in the partnership) in the year that was under review.
Any underpayment assessed would be calculated by multiplying the net adjustment for the audited year by the highest individual or corporate tax rate for that year under audit. However, a partnership liable for an underpayment may demonstrate to the IRS that a lower amount is appropriate based on a review of information at the partner level. For example, a partnership may demonstrate that a lower underpayment should be imposed if a portion of the underpayment is attributable to tax-exempt partners or to individual partners who pay tax on capital gains or dividends at lower rates. In these instances, the partnership agreement will need to address the division of liability among partners with varying tax positions.
Alternative Partner-Level Adjustment
At its election, a partnership can avoid paying, at the partnership level, the tax resulting from an audit adjustment. This election will shift the burden of any adjustment to those persons who were partners in the year under audit. A partnership must make the election within 45 days of the date of the notice of final partnership adjustment. The partnership must then issue adjusted Forms K-1 to those persons
who were partners in the year under audit. Each of those partners would then take into account any adjustments on their personal returns for the year in which they receive the adjusted Forms K-1, rather than by amending their returns for the year under audit. If this election is made by the partnership, the
partners will be required to pay a higher rate of interest on underpayments (federal short term rate plus five percent, rather than federal short term rate plus three percent).
Partnerships should consider revising their pre-existing partnership agreements to address whether
the partnership should make such an election. This would provide past, present, and future partners with a reasonable expectation as to the burden they would bear in the event of an audit. If a partnership were to choose to not make such an election, it should expect that prospective partners may request an
indemnity for any future partnership audits covering a year when that person was not a partner.
Opt-Out Option Available to Certain Partnerships
Certain partnerships can elect not to be subject to the new audit procedures. However, in order
to “opt out,” the partnership must have 100 or fewer partners and the partners must be individuals, C corporations (or any foreign entity that would be treated as a C corporation if it were domestic), S corporations, or estates of deceased partners. If any partner was, for example, another partnership or a
trust, then the partnership cannot elect to opt out. In addition, although a partnership with an S corporation as a partner is not precluded from opting out, each shareholder of the S corporation is treated as a partner of the partnership in determining whether there are 100 or fewer partners. If an
eligible partnership chooses to opt out, the partnership and partners would then be subject to the general audit procedures for individual taxpayers.[5]
Partnerships should consider carefully whether to require, or permit, opting out. The requirements
for eligibility are complex, and the notice and filing requirements are stringent. Moreover, the new procedures do provide potential administrative benefits, allowing proceedings under a streamlined process and thereby avoiding numerous individual audits. In any case, to provide certainty of treatment for the partners, partnership agreements should address whether an eligible partnership would or would not elect to opt out of the new audit procedures.
Additional Changes
Self-Adjustments – Under the Budget Act, a partnership can also file an administrative adjustment request if it believes that additional tax is due or that an overpayment was made, and the adjustment will be taken into account in the year of the adjustment. (This must be filed within three years of the later of (a) the date on which the partnership actually filed its return, or (b) the due date for filing the partnership return.) The partnership would then have the option to take the adjustment into account at the partnership level or to issue adjusted Forms K-1 to those persons who were partners in the year under review.
Partnership Representative – The Budget Act also requires each partnership to designate a partnership representative to have the sole authority to act on behalf of the partnership (a role similar to that of a tax matters partner under TEFRA). The partnership representative must have a substantial presence in the United States, but this representative does not have to be a partner. If a partnership fails to designate a partnership representative, the IRS may select any person to fill the role. It would be prudent for all partnerships to select their own partnership representative and revise their partnership agreements to address the election and replacement of the individual holding that position.
Statute of Limitations – Following the Budget Act, the statute of limitations for assessments of partnerships will be simplified into a single partnership statute of limitations, unaffected by the statute of limitations of each partner. Absent fraud or a substantial omission of income, a partnership
cannot be assessed more than three years after the latest of (a) the date the partnership filed its tax return, (b) the due date for the partnership’s tax return, or (c) the date on which the partnership filed with the IRS a request for an administrative adjustment to its previously filed tax return.
Conclusion
Partnerships should re-examine their partnership agreements and make any necessary revisions in
preparation for when the new audit procedures go into effect. In particular, partnerships will want to consider:
i. who (present or past partners) will bear the cost of an audit adjustment;
ii. how new tax liabilities will be divided among partners, and in particular whether the tax position of a partner will influence that division; and
iii. whether opting out of the new audit procedures should be required, or permitted.
If you have any questions about this article or would like additional information, please contact a member of our Tax Practice Group.
[1] The Bipartisan Budget Act of 2015 (HR 1314) was signed into law on November 2, 2015 (https://www.congress.gov/bill/114th-congress/house-bill/1314/text).
[2] Joint Committee on Taxation, Estimated Revenue Effects of the Tax Provisions Contained in H.R. 1314, the “Bipartisan Budget Act of 2015,” Scheduled for Consideration by the House of Representatives, October 28, 2015 (https://www.jct.gov/publications.html?func=startdown&id=4846).
[3] Large Partnerships: With Growing Number of Partnerships, IRS Needs to Improve Audit Efficiency (GAO report number GAO-14-732), Government Accountability Office (September 18, 2014) (http://www.gao.gov/assets/670/665912.txt).
[4] Although the new partnership audit procedures do not go into effect until 2018, a partnership can elect to be subject to these new partnership audit procedures for any partnership return filed for tax years beginning after November 2, 2015.
[5] Bipartisan Budget Act of 2015, Section-by-Section Summary (http://docs.house.gov/meetings/RU/RU00/CPRT-114-RU00-D001.pdf).