Tax Law Insights

The Bipartisan Budget Act of 2015 enacted sweeping changes to the federal audit regime for entities taxed as partnerships.  The new audit rules became effective for tax years beginning on or after January 1, 2018.

For tax years beginning before January 1, 2018, partnerships are audited using one of three different procedures (unless the partnership makes an affirmative election to be governed by the new partnership audit rules effective for tax years beginning before January 1, 2018).  These procedures are:

a. Partnerships with 10 or fewer partners: The Internal Revenue Service (Service) audits partners using procedures similar to individual taxpayer audits.  The Service will audit the partnership and each partner separately unless the partnership elects for the large partnership procedures to apply.

b. Large Partnerships (more than 10 partners): The tax treatment of any partnership item, including any additions to tax, interest, or penalties, is determined at the partnership level.  Once an audit concludes and proposed adjustments become final, the adjustments are passed through to the partners.

c. Electing Large Partnerships (100 or more partners): For those partnerships making an affirmative election to be treated as an electing large partnership (“ELP”), any adjustments made by the Service at the partnership level flow through to the partners for the tax year in which the adjustment are final and take effect.

For tax years beginning on or after January 1, 2018, any adjustment to items of income, gain, loss, deduction, or credit of a partnership for a partnership tax year (and any partner's distributive share of such adjustment) is determined at the partnership level.  Any tax attributable to such adjustment is assessed and collected, and the applicability of any penalty, addition to tax, or additional amount which relates to an adjustment to any such item or share is determined, at the partnership level.  The highest tax rate generally applies to any tax due as a result of the partnership adjustments.

The new partnership audit rules, which impose tax at the partnership level by default, raise a number of issues that all entities subject to the regime need to address in their governing documents.  The following is a brief summary of issues that should be addressed:

1. Election out of the new audit regime. Partnerships with 100 or fewer qualifying partners can elect out of the new partnership audit rules for any tax year (annual election that must be made on a timely filed return).  Qualifying partners include individuals, C corporations, foreign entities that would be treated as a C corporation were they domestic, S corporations, and estates of a deceased partner.  Partnerships and disregarded entities are not qualifying partners and any partnership with such partners cannot elect out of the new audit regime.

Governing documents should address whether a partnership will be required to elect out, if eligible.

2. Partnership Representatives. Every partnership is required to designate a partner (or other person) with a substantial presence in the United States as the partnership representative.  The partnership representative can be a member of the partnership, or any other person or entity with a substantial presence in the United States.  If the partnership does not designate a representative, the Service may select any person as the partnership representative.  The partnership and all partners are bound by actions taken by the partnership representative.  The partnership representative is designated annually on the partnership’s tax return.

Governing documents should be updated to designate a partnership representative and define the powers and limitations of the partnership representative.  Limitations on the partnership representative do not impact the partnership representative’s authority with the IRS, but provide contractual protections.  The governing documents should also address the responsibilities a partnership representative has if the representative is no longer a partner when an audit commences because the designation on a tax return continues applies for that tax year, regardless of whether the representative is or continues to be a partner.

3. Push-out elections. As an alternative to taking adjustments into account at the partnership level, a partnership can elect to take adjustments into account at the partner level instead of the partnership level.   This provision is referred to as the push-out election.

Governing documents should address whether the partnership will or will not make a push-out election, or provide a mechanism for determining whether the election will or will not be made.

4. Pull-in procedures. The tax a partnership is required to pay under the audit procedures can be modified or reduced if partners file amended returns or supply certain information to the IRS.

Governing documents should address partner obligations to comply with the pull-in procedures and how to determine whether the pull-in procedures should be elected.

5. Continuing partner liability. The new partnership audit regime is not concerned with former partners and benefits they may have received from deductions that are later disallowed on audit.  Continuing partners should be concerned with the manner partnership audit liabilities are allocated among current and former partners.

Governing documents should address the continuing liability of a former partner for partnership audit adjustments that are assessed after the former partner is no longer a partner.  Ordinarily, the partnership will want the former partner to continue to be responsible for its proportionate share of any partnership liabilities that are assessed for a tax year in which the former partner was still a partner.