On November 2, 2015, the Bipartisan Budget Act of 2015 (the “Budget Act”) was enacted, which contains 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 them, 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.
Existing Audit Regime
Under the existing law, enacted by the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”), the IRS has the burden of recalculating the tax liability of each partner in a partnership for the particular year subject to audit. The TEFRA regime passes 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
DOES NOT APPLY IF:
- LESS than 100 partners AND
- Only “Eligible Members” (i.e. Corporations, Individuals, Estates)
If the new rules do not apply, the partnership must elect out annually. Any partnership with a tax-exempt organization as a partner will need to determine whether the entity is a corporation or a trust for purposes of eligibility to elect out. We expect to see more guidance on the procedures in the coming months; however, here is a summary of the new audit regime:
- 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.
- As an alternative to item 1, if the partnership furnishes to each partner the partner’s share of adjustments within a specified period of time, then the adjustment would be included in the partner’s tax return for the year of adjustment (as opposed to amending the tax return for the year of audit).
- “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 Budget Act changes present numerous challenges for partnerships and their partners. For example, reallocations of income from one partner to another will result in a partnership level assessment of tax, based on the increases in income to one partner or group of partners, without taking into account a corresponding reduction in income allocation to other partners. The new rules could also shift the tax burden of any assessment to those persons that are partners in the year of assessment rather than flowing through the adjustments to the partners who recognized the benefits in earlier years.
Key questions you should ask include:
- Are Partners obligated to provide personal tax information to calculate adjustments?
- How will the partnership pay tax liability being assessed?
- How will the partnership allocate tax liability?
- Who is responsible for reviewed year partners’ tax adjustment related to adjustment year partner?
- Should the partnership be authorized to maintain a reserve? If so, how much? Under what conditions could the partnership distribute the reserve?
- Who is responsible if an election is missed? Is the Partnership Representative personally at risk?
The purpose of the new partnership audit procedures is to increase tax collections, so the number of partnership audits being sent to the IRS may rise. Your 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.
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