On November 2, 2015, the Bipartisan Budget Act of 2015 (the “Budget Act”) was enacted, which contained major changes to the partnership tax audit process. Under the Act, the IRS will now audit specified partnerships and collect tax attributable to any adjustments directly from the partnership, as opposed to pursuing the partners. These new rules are effective for tax years beginning in 2018 and are applicable to all entities treated as partnerships for federal income tax purposes. Members and investors will be significantly impacted by the new audit rules and affected partnerships should carefully consider making changes to their governing documents.
Previous Audit Regime
Under the old law, enacted by the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”), the IRS had the burden of recalculating the tax liability of each partner in a partnership for the particular year subject to audit. The TEFRA regime passed through any audit adjustments to the partners in the year under review.
The New Budget Act Regime
The new Budget Act repeals the TEFRA Rules, replacing them with a new partnership audit regime which is applicable to all partnerships meeting the following criteria:
- MORE than 100 members OR
- Partnership, Trusts, Disregarded Entities are members
May Elect out If:
- LESS than 100 partners AND
- Only “Eligible Members” (i.e. Corporations, Individuals, Estates)
- The option to elect out is made annually on a timely filed tax return
The new rules permit the IRS to impose a federal tax liability directly on the partnership.
- The partnership has the obligation to pay the tax deficiency, plus penalties and interest.
- Tax would be computed at the highest individual or corporate tax rate in effect for the year under examination.
- The partnership may be able to reduce its tax liability by providing a calculation to the IRS that some of its members are tax-exempt or are subject to lower tax rates.
On March 23, 2018 the Tax Technical Corrections Act of 2018 was signed into law which provided a “Pull-in” procedure whereby the partnership could propose partnership adjustments to the reviewed year members without the need for amended returns to be filed.
Another option exists known as the “Push-out” method which essentially is the same as the Pull-in procedure, but requires members to amend their returns. Choosing the Push-out method comes with an added penalty.
“Tax Matters Partner” is replaced with a “Partnership Representative” which may be a partner or other person with substantial presence in the United States. The Partnership Representative will retain broad authority to resolve any partnership audit and any such resolution will be binding on all partners.
The new rules could shift the tax burden of an assessment to those persons who are partners in the year of assessment rather than flowing through the adjustments to the partners who recognized the benefits in earlier years.
Impact on partnership agreements:
- Agreement on control of audit process
- Rights of partners
- Allocation of adjustments
- Treatment of former partners
- Potential disincentive for certain new entity members
The purpose of the new partnership audit procedures is to increase tax collections, so the number of partnership audits may rise. Existing partnership agreements should be reviewed and amended to address these new rules as well as choosing a Partnership Representative.
Such decisions should be reflected in the partnership agreements as well as offering memoranda and subscription documents. Additionally, all purchase and sale agreements should be carefully evaluated so that potential partners do not bear the costs of taxes associated with income or gain earned by partners in prior years.