The recently enacted Bipartisan Budget Act of 2015 amended existing Internal Revenue Code of 1986, as amended (the “Code”) rules governing tax audits of partnerships in the U.S. These new rules primarily impact partnerships with more than 100 partners and will generally apply to partnership taxable years beginning after December 31, 2017. A partnership may elect to apply the new rules to tax returns for partnership taxable years beginning after November 2, 2015 and before January 1, 2018. Certain partnerships with 100 (or fewer) partners may opt to elect out of the new rules and instead be subject to audits at the partner level.
Current Partnership Audit Rules
Currently, partnership audits are conducted under three different regimes depending on the number of partners in the audited partnership. Audits of partnerships with 10 or fewer partners are conducted at the partner level together with audits of a partner’s individual return. A partnership with 10 or more partners is audited at the partnership level, with any resulting adjustments resulting in redeterminations of the partners’ individual tax liabilities (and amended Schedules K-1 and partner tax returns) for the audited year(s). Finally, for a partnership with 100 or more partners that elects to be treated as an “electing large partnership,” any adjustments resulting from an audit of the partnership are generally taken into account by the partners on a current basis (i.e., in the year the audit is concluded), without adjusting any prior year returns relating back to the audited tax year.
New Audit Rules
The new rules replace the existing partnership audit regimes with a general regime and two noteworthy elective options. Under the general regime, audits of a partnership’s items of income, gain, loss, deduction or credit (including the partners’ distributive shares of those items) will occur at the partnership level, in a manner similar to the existing regime for electing large partnerships. Any adjustments will generally be taken into account by the partnership, instead of the individual partners, in the year in which the audit is concluded. In addition, any additional tax liability attributable to the adjustments will be assessed and collected (together with any penalties and interest) from the partnership based on an assumption that the highest applicable tax rate should apply. A partnership under audit will have the option to submit partner-level information relating to the year under audit (for example, amended partner returns, applicable tax rates applicable to certain partners or income allocated to those partners) to support a reduced adjustment. While such information may reduce the resulting partnership liability, it will not alter the requirement that the partnership bear such liability in the year in which the audit is concluded. As a result, persons who are partners during the year the audit is concluded will bear (indirectly) any additional tax liability attributable to the audit adjustments, irrespective of their interests (if any) in the partnership during the year under audit.
The new legislation will also replace the existing “tax matters partner” designation rules with a “partnership representative” concept. Going forward, the partnership representative will have sole authority to act on behalf of the partnership with respect to audits and partnership reviews. Future regulations will address the manner in which a partnership representative shall be designated, but it appears that the eligibility requirements will be more flexible than those currently applicable to tax matters partner designations. As amended, the statute will merely require that the partnership representative be “a partner (or other person) with a substantial presence in the United States.” Thus, the statute raises the possibility of designating a partnership representative who is not a partner in the partnership.
Observation: Although future regulations will likely further clarify the eligibility requirements for partnership representatives, the ability to designate a person other than a “general partner” or “managing member” (as is currently required when designating a tax matters partner) would be a welcome development. In particular, such flexibility would alleviate the uncertainty that arises when designating tax matters partners for “check-the-box” partnerships, as well as the difficulties faced by partnership sponsors that, for regulatory reasons, may be unable to act as general partners or managing members. On the other hand, it is unclear how the requirement that the partnership representative have “a substantial presence in the United States” will impact partnerships that have non-U.S. general partners or managing members who currently act as tax matters partners.
Election Out of Audit Regime for Certain Smaller Partnerships
Certain partnerships with 100 or fewer partners may opt out of the new general audit regime by making an affirmative election for each taxable year for which the partnership seeks to opt out of the new rules. Although similar to the existing regime for partnerships with 10 or fewer partners, additional conditions apply. Specifically, a partnership is eligible to elect out if:
- the partnership is required to furnish 100 or fewer statements under Section 6031(b) (i.e., Schedules K-1); and
- its partners consist solely of individuals, C-corporations, S-corporations, foreign entities that, if domestic entities, would be treated as C-corporations, and estates of deceased partners.
If an eligible partnership makes this election, certain procedural issues relating to an audit would need to be addressed directly by each individual partner. For example, the partnership would not be able to settle any audits on behalf of its partners and, instead, any settlement agreements or extensions of the statute of limitations must be agreed between each partner and the IRS.
Observation: Notably, the presence of a partner that is itself a partnership (or a trust) will cause a partnership to become ineligible for this election. Presumably, the drafters of the legislation were concerned that tiered partnership (or trust-partnership) structures could circumvent the 100-partner limit, although this could have been addressed with a look-through rule. Commonly used partnership vehicles that will be ineligible for this election include master funds having partnership feeder funds, pooled trading vehicles that have investing partnerships, and investment partnerships that serve as investment options for certain funds of funds.
Election Out of Current Year Liability
The new rules permit a partnership to opt of bearing current year liability for any additional tax liabilities associated with audit adjustments relating to prior audited years. The partnership must make such an election within 45 days of a final adjustment. The election would result in such tax liabilities being borne by the persons who were partners during the year under audit, rather than the year in which the audit was concluded. A partnership that elects this option would furnish to each person who was a partner during the year under audit a statement of the partner’s share of the final partnership adjustment. Each such partner would reflect its portion of the adjustment amount (including any associated penalties and interest) in its current year tax return. As a result, any additional tax liabilities would be allocated more fairly among those persons who were partners during the audited year, while still avoiding any requirement for the partnership or those partners to amend prior year Schedules K-1 or partner tax returns. It should be noted, however, that this more streamlined approach comes at the cost of a higher interest charge. In general, the rate of interest on underpayments of tax is determined by increasing the federal short-term rate by three percent. Under this election, however, interest is charged at the federal short-term rate plus five percent. Observation: The availability of this option, which eliminates current year partnership liability without requiring amended Schedules K-1 or partner tax returns (albeit at the cost of increased interest rates), would appear to be the favored choice for any partnership not otherwise eligible to opt out of the general partnership audit regime entirely by making the election available for certain smaller partnerships (described above). Subject to forthcoming regulatory clarifications, this option also seems preferable to the partnership audit regimes currently applicable to partnerships having more than 10 partners.
Practical Considerations / Market Practice
For purposes of the new partnership audit rules, a “partnership” is defined broadly to include any entity treated as such for U.S. federal income tax purposes (including entities that elect to be treated as partnerships under the so-called “check-the-box” rules). Accordingly, these new audit rules potentially will affect any partnerships that file U.S. partnership returns, including U.S. partnerships (and limited liability companies treated as partnerships) and most non-U.S. partnerships with U.S. partners (either directly or indirectly through one or more tax transparent entities).
While we expect that forthcoming regulations will contain more detailed guidance (particularly in respect of the election to opt out of current year partnership liability), a few steps should be taken now.
Operating agreements of existing partnerships should be updated to address how partnership audits will be handled once the new rules become effective, such as who will designate (or be designated as) the partnership representative. In addition, consideration should be given to whether the partnership representative will be given broad authority to make all available elections (for example, electing out of the new audit rules or electing out of current year partnership liability). In the event that neither such election is made, a partnership may consider allocating to audit year partners, or “clawing back” from such partners, any resulting current year tax liability that is borne by the partnership. The partnership may also consider imposing indemnification obligations on withdrawing partners. For affected partnerships that are fund vehicles, offering documents should contain updated disclosures reflecting the new partnership audit rules. Some partnerships may wish to develop a definitive stance on whether to make any available elections prior to admitting partners or entering into any investor side letter negotiations.
The discussion above highlights only some of the issues confronting partnerships and their partners with respect to the new partnership audit rules. Although many aspects of the new rules require further clarification, what is clear is that these rules will significantly change the administration of partnership audits. Although these changes generally will not take effect until after December 31, 2017, however, partnerships and their partners should start preparing now.