In 2015, Congress passed the Bipartisan Budget Act that created a new Centralized Partnership Audit regime that is effective for income tax returns filed of partnership taxable years beginning after December 31, 2017. These new changes will impact the ways partnerships structure their partnership agreements and the way they interact with the IRS.

I.    Reporting Requirements of Partnerships Generally

For federal income tax purposes, a partnership is not a taxable entity. Instead, a partnership is a conduit, and the items of partnership income, deduction, gain, loss, and credit are taken into account on the partners' income tax returns. A partnership is required to file an annual information return setting forth items of partnership information necessary to carry out the income tax (Form 1065) and to furnish to each partner a statement of such partnership information as is relevant to the partner's income tax (Schedule K-1).

II.    Prior Partnership Audit Rules – TEFRA Unified Partnership Audit Rules

The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) established unified rules. These rules required the tax treatment of all “partnership items” to be determined at the partnership level in a single administrative proceeding, rather than the partner level. Partnership items are those items that are more appropriately determined at the partnership level than at the partner level.  Any item that is affected by a partnership item (for example, on the partner's return) is an “affected item.” Affected items of a partner are subject to determination at the partner level.

Upon completion of partnership-level determinations, the IRS collected tax from each partner separately with respect to deficiencies at the partner level.  Under prior law, the IRS was required to audit each partner separately, which lead to multiple audits on identical transactions/issues, often with disparate results.

III.    New Partnership Audit Rules – Centralized Partnership Audit Regime

The Bipartisan Budget Act of 2015 (the BBA) repealed TEFRA and Electing Large Partnership rules and replaced them with a Centralized Partnership Audit regime effective for returns filed for partnerships’ taxable years beginning after December 31, 2017.

Under the centralized system, the flow-through nature of the partnership is unchanged, but the partnership is treated as a point of collection of underpayments that would otherwise be the responsibility of partners. The return filed by the partnership, though it is an information return, is treated as if it were a tax return where necessary to implement examination, assessment, and collection of the tax due and any penalties, additions to tax, and interest. Any tax attributable to these items is assessed and generally is collected at the partnership level as an imputed underpayment paid by the partnership with respect to the adjustment year rather than the reviewed year.   
* Practice note – the concept of partner-level proceedings to address partner-specific facts/defenses no longer exists.

If an eligible partnership elects outs, the present-law rules for deficiency proceedings applies (i.e. TEFRA).  A partnership is eligible if it has 100 or fewer partners during the taxable year and all of the partners are eligible partners, meaning an individual, C corporation, any foreign entity that would be treated as a C corporation were it domestic, an S corporation, or an estate of a deceased partner. Absent specific guidance by the IRS, a partnership will not be able to make this election if any partner during the taxable year is a partnership, disregarded entity (i.e. single member limited liability company), trust, or non-qualifying foreign entity or estate.

If the partnership satisfies the eligibility tests, an electing partnership must make the election out separately for each taxable year by claiming the election on its timely-filed income tax return (including extensions). The partnership must disclose to the IRS, for each partner (and each person that was a shareholder in an S corporation partner) at any point during the taxable year, such partner’s name, taxpayer identification number, federal tax classification, and an affirmative statement that each partner is an eligible partner. In addition, the partnership must notify each partner within 30 days after making the election in the form and manner determined by the partnership.

IV.    Comparison of Key Changes

A.    Representative

Prior Law: Tax Matters Partner as the primary representative of a partnership in dealings with the IRS.

BBA: Partnership Representative has sole authority to act on behalf of the partnership under the centralized system.  
* Practice note – Partnership needs to add a provision to its partnership agreement if it wants the Partnership Representative restricted by consent of the other partners for any particular action.

B.    Notice

Prior Law: The IRS generally is required to give notice to the partners separately of the beginning of partnership-level administrative proceedings and any resulting administrative adjustment to all partners whose names and addresses are furnished to the IRS.

BBA: There is no longer a requirement to give partners notice of any audit commencement, negotiations, etc. All information is conducted through the Partnership Representative.  

The centralized system contemplates three types of notifications by the IRS to the partnership and the Partnership Representative: (1) notice of any administrative proceeding initiated at the partnership level; (2) notice of a proposed partnership adjustment resulting from the proceeding; and (3) notice of any final partnership adjustment resulting from the proceeding. A partner could have no knowledge of the audit and receive a bill in the mail from partnership to pay in for the partnership liability.  

There is no concept of a “notice partner” under the BBA, and the IRS is not required to notify anyone other than the Partnership Representative regarding the audit or any adjustments. There are also no statutory requirements that the Partnership Representative keep the other partners informed of the partnership proceedings.
* Practice note – Partnership needs to add a provision to its partnership agreement if it wants the partners to get any notice regarding IRS contact.

C.    Requirement of Consistency with Partnership Return

Prior Law: Partners are required to report partnership items consistently with the partnership's reporting, unless the partner notifies the IRS of inconsistent treatment. Additional tax attributable to an adjustment of a partnership item is assessed against each of the taxpayers who were partners in the year in which the understatement of tax liability arose.

BBA: An underpayment that results from a failure of a partner to conform to the partnership reporting of an item is treated as a math error on the partner's return and cannot be abated. The underpayment may be subject to additions to tax.

D.    Partners' Ability to Challenge Partnership Treatment; Adjudication of Disputes Concerning Partnership Items

Prior Law: Partners have rights to participate in administrative proceedings at the partnership level, and can request an administrative adjustment or a refund for the partner's own separate tax liability. To the extent that a settlement is reached with respect to partnership items, all partners are entitled to consistent treatment.  After the IRS makes an administrative adjustment, the Tax Matters Partner (and, in limited circumstances, certain other partners) may file a petition for readjustment of partnership items in the applicable court.

BBA: The partnership and the partners are bound by all actions taken by the Partnership Representative. Partners have no rights to participate in the partnership proceeding.  
* Practice note – Partnership needs to add a provision to its partnership agreement if it wants to require partners (current/former) to cooperate by providing information or if partners want to participate/have a voice in the proceedings.  

E.    BBA Concept –Reviewed Year vs. Adjustment Year

Reviewed Year: The partnership tax year being audited by the IRS.

Adjustment Year: The year in which the adjustment is made or becomes final.   

Section 6225 Payment: The default rule where the partnership pays the imputed underpayment.  

Imputed Underpayment: Means the net adjustments by the IRS multiplied by the highest tax rate (highest rate of federal income tax applicable either to individuals or to corporations that is in effect for the reviewed year). Adjustments to imputed payments could be made to account for certain partners’ tax attributes.  
* Practice note – Partnership needs to add a provision in its partnership agreement to require review year partners to provide such information.

A situation could arise where a partner is a partner in the review year with respect to which the audit adjustment relates that is no longer a partner in the adjustment year when the partnership must pay deficiency.

A new partner in the adjustment year could be responsible for the cost of an adjustment arising from review year when was not a partner.
* Practice note – Partnership needs to address review year partner indemnification, including indemnification from persons who may no longer be partners, in its partnership agreement, as well as any redemption agreement or partnership interest purchase agreement.

Imputed Tax Liability – Reduce by Amended Returns: Adjustments to imputed underpayments could be made through amended returns; imputed underpayment is ultimately borne by the partners in the adjustment year, and there is generally no requirement to file amended returns. In the case of an adjustment that reallocates the distributive share of any item from one partner to another, this modification procedure is only available if amended returns for the reviewed year are filed by all partners affected by the adjustment.  
* Practice note – Partnership needs to address in its partnership agreement if it wants to require partners (review year partners) to file amended returns in order to reduce tax liability in adjustment year for adjustment year partners.

Imputed Tax Liability – Push-Out Election: As an alternative to partnership payment of the imputed underpayment (i.e. payment of review year partners’ tax liability by adjustment year partners), a partnership may elect to push-out the adjustment to the partners from the reviewed year. The election ensures that the review year partners bear the cost of the adjustments and protects the partners from the adjustment year from bearing the burden of income earned in prior periods. If the push-out election is made, the underpayment interest rate is increased by 2% (but for corporate taxpayer the interest may be deductible).                                                                                  * Practice note – Partnership needs to address in its partnership agreement whether it wants to make the push-out election.
 
Opinions and conclusions in this post are solely those of the author unless otherwise indicated. The information contained in this blog is general in nature and is not offered and cannot be considered as legal advice for any particular situation. Any federal tax advice provided in this communication is not intended or written by the author to be used, and cannot be used by the recipient, for the purpose of avoiding penalties which may be imposed on the recipient by the IRS. Please contact the author if you would like to receive written advice in a format which complies with IRS rules and may be relied upon to avoid penalties.

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