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New Audit Procedures Alter Federal Income Tax Treatment of Partnerships

12.15.15

Background

On November 2, 2015, the Bipartisan Budget Act of 2015 (the “Budget Act”) was enacted, which contains provisions that include major changes to the partnership tax audit process. This process provides that the IRS will audit and collect tax from partnerships at the entity level. The new rules are effective for tax years beginning in 2018 and are applicable to all entities treated as partnerships for federal income tax purposes, including limited liability companies that have not elected to be treated as corporations. Private equity funds, hedge funds, MLPs and other partnerships, as well as their investors, will be significantly impacted by the new audit rules and should carefully consider making changes to their governing documents.

Existing Audit Regime

Under 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 establishes a category of “partnership items” for which tax treatment must be determined at the partnership level – a TEFRA audit focuses on those partnership items, and passes through any audit adjustments to the partners in the year under review. The existing law also includes elective simplified audit procedures for large partnerships with 100 or more partners that only apply when a large partnership makes the election. For certain partnerships with 10 or fewer partners, the TEFRA rules do not apply and the IRS generally conducts separate audits for each partner.

The New Budget Act Regime

The new Budget Act repeals both the TEFRA Rules and the electing large partnership rules, replacing them with a new partnership audit regime which is applicable to all partnerships other than partnerships with 100 or fewer partners meeting certain requirements. Partnerships with 100 or fewer partners that are individuals or corporations may elect out of these rules. If a partnership has 100 or fewer partners, and one of the partners is a partnership or a trust, the partnership is not eligible to elect out of the new partnership rules.

We expect to see more guidance on the procedures in the coming months; however, here is a high level summary of the new regime:

  1. 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 Budget Act authorizes the IRS to prescribe rules that will allow a partnership to reduce the liability by demonstrating, for example, that some of its partners are subject to a lower rate or are tax-exempt. Tax is imposed on the partnership irrespective of any changes in ownership of the partnership that might have occurred between the taxable year in which the partnership items arose and the taxable year in which the partnership items are finally adjusted.
  2. As an alternative to #1 above, 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).
  3. The new rules replace the concept of “tax matters partner” with a partnership’s designated “partnership representative” that 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 cost 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.

Considerations

The purpose of the new streamlined partnership audit procedures is to increase tax collections from partnership audits, and accordingly, it is likely that the number of partnership audits will increase. Existing partnership agreements will need to be reviewed and revised to address the new audit rules. Partnerships and their partners will need to make decisions on whether or not the partnership will elect out of the new entity level audit procedures (if applicable) and/or designate the partnership representative who will act on behalf of the partnership.

Such decisions should be reflected in the partnership agreements as well as offering memoranda and subscription documents in the case of private equity funds, hedge funds, MLPs and other pooled investment vehicles, which are treated as partnerships for federal income tax purposes. 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.