All partnerships will be audited at the entity level unless they have 100 or fewer partners AND no partnerships as direct partners.
The two-year budget plan passed by Congress on October 30, 2015, and expected to be signed into law by President Barack Obama on November 2, 2015, includes a complete overhaul of the procedure for examining partnership returns and collecting resulting deficiencies. The legislation aims to create a single, streamlined set of partnership audit rules and repeals the 1982 Tax Equity and Fiscal Responsibility Act (TEFRA) unified partnership audit rules as well as the electing large partnership rules for taxable years beginning after December 31, 2017.
Broadly, the legislation eliminates the ability of partners to participate in partnership examinations and empowers a sole partnership representative (who need not be a partner) to control partnership examinations and bind all partners. It also makes the partnership directly liable for any deficiencies, but provides two mechanisms whereby the partnership can shift part or all of any deficiency obligation to the persons who were partners in the partnership in the year under examination.
These rules will apply to all partnerships that have more than 100 partners or who have a direct partner that is classified as a partnership for federal tax purposes. Partnerships that have 100 or fewer partners and no partnerships as partners can elect out of the new regime. Below, we describe the key aspects of the new legislation and outline certain practical implications for partnerships and their partners.
Practical Considerations #1
Unlike the “tax matters partner” under the prior TEFRA rules, the partnership representative need not be a partner. Moreover, partners will now have no statutory right to participate in tax audits or litigation and will have no right to opt out of the partnership-level proceeding. Further, if the partnership does not select its representative, the new rules allow for the Internal Revenue Service (IRS) to appoint any person to represent the partnership.
Because the partnership directly pays any deficiencies upon completion of the audit, the current-year partners bear the burden of the adjustments, rather than those who were partners in the year of the adjustments.
Partners who want to participate in IRS examinations and have a say in settlement and litigation decisions will need to make sure that the partnership agreement provides desired participation rights.
Eligible partnerships should consider whether to amend their agreements now to require that the partnership elect out of the new regime and should consider prohibiting any partnership from becoming a partner. Eligible partnerships that currently have other partnerships as partners should consider eliminating those partners.
However, partners should not assume that electing out of the new rules is desirable. The alternative is that all partnership issues will be examined, adjusted, and litigated in partner-by-partner deficiency proceedings.
Under the new rules, if a partnership audit or litigation results in a net increase in partnership taxable income, the partnership will be directly assessed an amount (an “imputed underpayment”) equal to the highest applicable tax rate multiplied by the net positive adjustment. The imputed underpayment (or any interest on it) is not deductible by the partnership, but will be treated as a nondeductible partnership expense in the year when the adjustment is finalized. For example, assume that in 2019, B buys a partnership interest from A, and that in 2020, the IRS increases the partnership’s 2018 taxable income. Under the current regime, A would owe tax on its share of the increase in 2018 income. Under the new legislation, the partnership will be required to pay those taxes in 2020.
Practical Considerations #2
The rules provide that the partnership is not entitled to a deduction for “any payment required to be made by a partnership” under these new rules. Instead, the imputed underpayment will be treated as a nondeductible expense of the persons who are partners in the year when the adjustment is finalized. This expense should result in a reduction to basis, under Section 705(b), and a reduction in the partners’ capital accounts.
Arguably, the inability to deduct extends to the interest paid on the imputed underpayment.
On the other hand, if the examination for the year does not result in an imputed underpayment—for example, because income reported in the year is reduced to reflect an increase in partnership income for a prior year (including a prior year that is not subject to the new regime)—the IRS does not pay an imputed overpayment to the partnership. Instead, for the partnership tax year in which the partnership proceeding is concluded, the partnership reduces the income that it reports to its partners as residual taxable income under Section 702(a)(8).
If the result of an examination is a reallocation of income or deductions from one partner to another (i.e., there is no net adjustment to the partnership’s income for the year), the partnership must make a payment equal to a deemed underpayment computed by reference to income that is reallocated to a partner, but must claim a Section 702(a)(8) reduction for the correlative income that is reallocated from partners.
Practical Considerations #3
Partnerships that want to ensure who will bear the burden or benefit of partnership adjustments will need to include appropriate indemnification provisions in their partnership agreement. Similarly, persons who are considering investing in or acquiring interests in partnerships will need to pay more attention to the partnership’s prior tax returns and potential partnership-level tax liability.
The new regime provides two alternative means by which a partnership (and persons who are its partners when the partnership proceeding is complete) can shift the monetary burden back to persons who were partners in the year under examination. Under one procedure, when a partnership proceeding is complete and the partnership would otherwise have to pay the imputed underpayment, anyone who was a partner in the year under review may file an amended return and pay tax on its share of the adjustment. Such amended returns may be filed even if the partner-level statute of limitations on amended returns has expired. Any adjustments reflected on partner-level amended returns will reduce the amount used to compute the partnership-level imputed underpayment.
This procedure apparently applies only to partners whose tax liability increases as a result of the partnership proceeding. A partner whose tax liability for the reviewed year would decrease has no ability to claim the benefit on his or her own return. Instead, the benefit is effectively treated as a partnership deduction for the partnership year in which the partnership proceeding is finalized.
Practical Considerations #4
The partnership-level underpayment is adjusted only if and to the extent that persons who were partners in the reviewed year actually file amended returns. A partnership that wants to avail itself of this option to avoid partnership-level liability will need to modify its agreements to require persons who were partners in the reviewed year to file amended returns. Further, to calculate the effect of a partner’s amended return on the partnership’s underpayment obligation, the partnership may need to have information regarding the amended returns. This raises potential privacy issues.
It is unclear whether a partner would be able to raise other unrelated adjustments, not previously claimed, that would otherwise be barred under statute of limitation provisions, to offset the imputed underpayment.
Under the second procedure to avoid partnership-level assessment and payment, a partnership may elect to shift the payment burden to the persons who were partners in the year at issue and notify them of their shares of any adjustments reflected in the final partnership adjustment (FPA). Those partners will then be required to compute the impact of the adjustment on their tax liability for the year under audit, but instead of filing amended returns for the audit year, they will pay the tax increase with their tax returns for the year in which the case is resolved and pay interest on the partnership-related tax at a rate that is 2% higher than the normal underpayment rate. This procedure apparently applies only to partners whose tax liability increases as a result of the partnership proceeding. A partner whose tax liability for the reviewed year would decrease has no ability to claim the benefit on his or her own return. Instead, the benefit is effectively treated as a partnership deduction for the partnership year in which the partnership proceeding is finalized.
The table below summarizes at a high level the alternatives presented by the new regime for resolving IRS-initiated adjustments.
Alternative Methods of Satisfying Underpayments
Partnership pays imputed underpayment.
Partner(s) file amended returns taking adjustments into account and paying tax thereon.
Partnership elects to have partners take adjustments into account.
Within 270-day period after notice of proposed adjustment is mailed.
Election made within 45-day period after date of FPA; Secretary to determine time for furnishing to partners a statement of additional income, gain, loss, deduction, or credit; partners’ tax increased in taxable year, which includes the date that partnership provides statement.
How the Amount is Determined
Net all adjustments of income, gain, loss, or deduction, and multiply by highest tax rate in effect for the reviewed year, but ignore any decrease in item of income or gain and increase in item of deduction, loss, or credit reallocated to another partner.
Imputed underpayment is determined without regard to the portion of the adjustments taken into account above.
Amount by which a partner’s tax for the taxable year, which includes the end of the reviewed year, would increase, plus any increases to tax in intervening years due to adjustments to tax attributes.
Applicable underpayment rate from the day after the return due date for the reviewed year to the return due date for the adjustment year.
Not specifically addressed by the legislation.
Applicable underpayment rate from due date of return for taxable year to which increase is attributable, determined by substituting 5 percentage points for 3 percentage points in § 6621(a)(2).
Although these new provisions will apply to returns filed for partnership taxable years beginning after December 31, 2017, a partnership may elect for the provisions to apply to any return for taxable years beginning after the date of enactment and before January 1, 2018. For those partnerships that elect out of these new rules, any examination of and adjustments to partnership items will be made on a partner-by-partner basis in partner-level deficiency proceedings.
Practical Considerations #5
There is a plethora of questions about how these new rules will work, and the legislation provides broad grants of regulatory authority for the Department of the Treasury to promulgate guidance as to how the rules will be administered. The new regime appears to be designed to make it easy for the IRS to assess and collect tax on adjustments to partnership items and difficult for partnerships to escape partnership-level payment. Further, transition rules may be needed, especially for audit issues that straddle or affect both years subject to TEFRA and years subject to the new regime.
The delayed effective date allows partners and partnerships time to prepare for the new regime. However, existing partnerships will want to move fairly quickly to review and amend their agreements in anticipation of the changes, and new partnerships will want to anticipate these new rules in their agreements. Purchasers of interests in existing partnerships should consider the possible effect of the new rules on their investments. For partnerships that wish to avoid the new regime, steps may be necessary to ensure that the partnership qualifies to elect out, such as the elimination of partnerships from the ranks of its partners.
Morgan Lewis’s tax partners have a long history in both structuring complex partnership transactions and representing partnerships and partners in partnership examinations, controversies, and litigation.
If you have any questions or would like more information on the issues discussed below in this LawFlash, please contact any of the following Morgan Lewis lawyers:
William F. Nelson