By: Jonathan Christianson and Brian Bowen
Under existing law, except for small partnerships, Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”) partnership audits of partnerships and limited liability companies that file as partnerships (“Partnership Entities”) occur at the partnership level, but the income tax due is assessed and collected at the partner level. As a result, audits of Partnership Entities are currently burdensome and expensive for the Internal Revenue Service (“IRS”). In an attempt to simplify TEFRA audit procedures and to streamline the collections process, Congress has enacted new rules governing partnership audits in The Bipartisan Budget Act of 2015 (the “New Rules”) which will replace the existing rules governing partnership audits for most Partnership Entities.
Audits for 2017 and before will continue to be under the old TEFRA audit rules. The new rules apply to audits of tax years beginning after December 31, 2017; that is, for partnership tax years beginning on January 1, 2018 or later. Under the New Rules, additional tax resulting from audit adjustments will be assessed and collected at the Partnership Entity level and, with certain exceptions discussed below, the Partnership Entity will be responsible for payment of any taxes and penalties that are assessed or will receive any refund that may be allowed. As a result, the tax burden or refund benefit from a prior tax year may be shifted from former partners in the year under review to partners who continue as partners at the time of the audit adjustment. For example, a person admitted as a partner in 2019 might be required to bear the tax liability resulting from an audit adjustment relating to a tax period before that person became a partner. Unless addressed in the Partnership Entity’s governing documents, potential new investors may be reluctant to become partners, especially if the entity has previously engaged in tax deferred transactions such as like-kind exchanges.
Under the New Rules, a “partnership representative” replaces the “tax matters partner” required under existing law. Unlike the tax matters partner, the partnership representative has exclusive authority to act on behalf of the Partnership Entity with respect to the resolution of an audit, including the authority to appeal an assessment or settle with the IRS or other taxing agency. The actions of the partnership representative will bind the Partnership Entity and all of the partners at the time of the assessment. Beginning on January 1, 2018, the Partnership Entity’s governing documents must identify the partnership representative. The governing documents should also specify how a successor is appointed or removed and define the scope of the partnership representative’s discretion to resolve audit issues without the consent of the partners. Decisions made by the partnership representative in connection with an audit may have significant economic effects on the Partnership Entity and the continuing partners.
A particularly vexing feature of the New Rules is that the assessment of tax at the Partnership Entity may result in the imposition of tax on individuals who were not partners during the audited year and, conversely, the avoidance of tax by partners who withdrew as partners before the assessment of additional tax. As a result, the Partnership Entity should consider whether an indemnification provision should be included in the partnership agreement so that all persons who were partners during the audited year are ultimately responsible to the IRS or the Partnership Entity for any tax liability that would have been allocated to and paid by such partners. Similarly, the partners might consider whether a former partner should be compensated for any additional loss allocation or refund that would have benefitted such former partner.
Certain Partnership Entities may elect out of the New Rules (in which case the old audit rules apply). To qualify, the electing partnership must have 100 or fewer partners, and all of its partners must be individuals, corporations, estates of deceased partners or foreign entities treated as C corporations. If a Partnership Entity has, as a partner, another partnership, a disregarded entity, a trust or even, it appears, a revocable living trust, then the Partnership Entity is not eligible to elect out of the New Rules. The election out of the New Rules is made with a timely filed tax return for the Partnership Entity for each taxable year and includes a disclosure of the name and taxpayer identification number of each partner of the Partnership Entity. The Partnership Entity must also notify each partner of such election. Since most Partnership Entities are owned by legal entities, disregarded entities or trusts, we expect that few Partnership Entities will be eligible to elect out of the New Rules.
Although the Partnership Entity may be unable to elect out of the New Rules, a Partnership Entity can, in some instances, “push” the additional tax liability out to the partners. To do so, a Partnership Entity must make an election within forty-five (45) days after the final notice of adjustment. If the election is made, the Partnership Entity must provide to each partner a statement of the partner’s share of the final partnership adjustment for the year of the audit. Each partner for the year of the audit is then responsible for paying tax on such partner’s share of the adjustment, which includes a higher interest charge than normally imposed. For the election to be effective, the Partnership Entity must also provide the IRS with the current address and taxpayer identification number for each partner and any former partners who were partners in the year being audited. Failure to provide current information for all such persons renders the Partnership Entity liable for the additional tax or penalties assessed. As a consequence, the partners should consider amending the Partnership Entity’s governing documents to require each partner and any former partner for a specified period to advise the Partnership Entity of any change of address or taxpayer identification number.
A Partnership Entity’s governing documents should be drafted or amended to conform to the New Rules. At a minimum, a Partnership Entity’s governing documents must identify the partnership representative and should specify the scope, authority and obligations of the partnership representative, the current partners and the former partners with respect to an audit. In addition, the partners should consider whether it is in their interest to provide an indemnification mechanism in the partnership agreement designed to match the tax benefit or liability with the partners who were partners during an audited year.
If you have any questions on how the New Rules will affect your Partnership Entity, or desire to amend your entity’s governing documents, contact a tax attorney at Boutin Jones Inc.
Legal disclaimer: The information in this article (i) is provided for general informational purposes only, (ii) is not provided in the course of and does not create or constitute an attorney-client relationship, (iii) is not intended as a solicitation, (iv) is not intended to convey or constitute legal advice, and (v) is not a substitute for obtaining legal advice from a qualified attorney. You should not act upon any of the information in this article without first seeking qualified professional counsel on your specific matter.