On January 18, 2017, the IRS released proposed regulations (the "Proposed Regulations") to implement Section 1101 of the Bipartisan Budget Act of 2015 (BBA),¹ which replaces the current rules governing partnership audits—commonly known as TEFRA—with a centralized audit regime that assesses and collects taxes at the partnership level (the "Centralized Audit Regime"). The Proposed Regulations are intended to apply to taxable years of partnerships that begin after December 31, 2017, and to partnerships that elect to have the Centralized Audit Regime apply for taxable years beginning after November 2, 2015. However, under an executive order signed on January 20, 2017, the Proposed Regulations are being sent back to the IRS to be reviewed by an agency head appointed by the new administration and, therefore, will not be applicable until after such review takes place and the Proposed Regulations are deemed acceptable.

The Centralized Audit Regime provides that, subject to certain exceptions described below, IRS adjustments to items of income, gain, loss, deduction, or credit of a partnership for a partnership taxable year, and each partner's distributive share of such adjustments, are to be determined at the partnership level. Consequently, any resulting adjustments to the partners' tax liability resulting therefrom, including any penalties, will be assessed and collected at the partnership level. Factors to be taken into account in making such determinations and adjustments will include: (i) whether a partnership exists; (ii) the partnership's accounting methods; and (iii) the potential application of the economic substance doctrine. Similarly, any penalty defenses must be raised at the partnership level.

The Centralized Audit Regime also requires each partnership to designate a "partnership representative." Under the Centralized Audit Regime, it is mandated that such partnership representative has broad authority to bind the partnership and the partners to any settlement reached with the IRS. Consequently, it would be prudent for partnership agreements to include notice and consent rights with respect to partnership audits and settlements with the IRS as well as with respect to other powers of the partnership representative (discussed further below).

The Proposed Regulations provide rules for partnerships subject to the new Centralized Audit Regime, including:

• when and how a partnership may elect out of the Centralized Audit Regime;
• the requirement of consistency between a partnership's and its partners' returns;
• requirements related to the partnership representative;
• the determination of imputed underpayments;
• the procedures for modifying imputed underpayments;
• the procedures for electing an alternative to the payment of imputed underpayments (the "Section 6226 Election"); and
• the procedures and requirements for audit adjustment requests.

A summary of some of the key features of the Centralized Audit Regime and the Proposed Regulations follows.

When and How a Partnership May Elect Out of the Centralized Audit Regime

The Centralized Audit Regime and the Proposed Regulations provide that each year a partnership may elect out of the Centralized Audit Regime provided that the partnership has 100 or fewer partners and each partner is an "eligible partner." For this purpose, an eligible partner is an individual, a C corporation, a foreign entity that would be treated as a C corporation if it were a domestic corporation, an S corporation, or an estate of a deceased partner. Thus, a partnership that has a pass-thru entity as a partner may not elect out of the Centralized Audit Regime. An election out is made on the partnership's timely filed tax return (including extensions) and must include, inter alia, the name, taxpayer identification number (TIN), and federal tax classification of each partner (and in the case of an S corporation partner, the name, TIN, and federal tax classification for each shareholder of the S corporation) as well as a statement that each partner is an eligible partner.

Partnerships that elect out of the Centralized Audit Regime will be subject to the pre-TEFRA rules for the assessment and collection of tax pursuant to which the IRS must separately assess and collect tax with respect to each partner under the deficiency procedures under subchapter B of chapter 63 of the Code.

Consistency Requirements Between Partnership's and Partners' Returns

Under the Centralized Audit Regime and the Proposed Regulations, partners' returns must be consistent in all respects with the partnership's return (even if the partnership furnishes the partner an incorrect Schedule K-1 or similar schedule). To the extent that a partner's return is inconsistent with a partnership's return, the partner's returns may be adjusted immediately by the IRS to ensure its consistency with the partnership's returns. There is an exception to this rule if a partner provides notice of the inconsistency and the IRS agrees to such inconsistency. The Proposed Regulations clarify that in the event of an identified inconsistency, the IRS may audit the partner (without involving the partnership) or the partnership.

Obviously, these provisions limit the partners' flexibility to disagree with the partnership's tax reporting, and where there are discrepancies, audit risk will be increased. Consequently, where practical, partners should seek rights to exercise control over, or at least have the right to comment on, partnership returns and the accuracy of Schedule K-1s and similar schedules. If it is not practical to provide partners with review rights, such as where there are a large number of partners, a careful review of the partnership's internal controls should be made and great care should be exercised in the selection of the partnership representative.

Requirements Related to the Partnership Representative

Each partnership is required to designate a partnership representative that will have broad authority to bind the partnership and each of the partners. To serve as a partnership representative, a person must have a substantial presence in the U.S. (i.e., the person must: (i) be available to meet in person in the U.S. with the IRS at reasonable times and places; (ii) have a street address and telephone number in the U.S.; and (iii) have a TIN) and if the partnership representative is not an individual, the partnership must appoint an individual with a substantial presence in the U.S. to act on behalf of the entity partnership representative.

Under the Centralized Audit Regime and the Proposed Regulations, the partnership representative has the authority to bind the partnership and the partners and is not required to provide to the partners notice of, or participation rights in, a partnership-level proceeding. As such, and as specifically articulated in the Proposed Regulations, partners may not participate in or contest the result of an examination or other proceeding involving the partnership without the permission of the IRS.

As the partnership representative will be the sole point of contact for the IRS and can bind the partnership and its partners, partners should endeavor to include strong contractual protections in the partnership's governing documents with respect to interactions with the IRS. In particular, the partnership representative should be required to provide each partner with notice of any audit action and a copy of IRS communications, and the ability of the partnership representative's right to take any action or inaction, such as to litigate or settle, should be subject to partner consent.

The Determination of Imputed Underpayment

Under the Centralized Audit Regime, if a partnership adjustment results in an imputed underpayment, subject to certain exceptions, the partnership (as opposed to the partners) must pay the imputed underpayment in the taxable year in which the adjustment is made. The imputed underpayment is calculated by multiplying the total net partnership adjustment by the highest marginal federal income tax rate in effect for the reviewed year, reduced by allowable partnership credits. For these purposes, adjustments may be grouped together according to whether each adjustment reallocates items among partners (reallocation grouping), adjusts the partnership's credits (credit grouping) or has another effect (residual grouping). Groupings may be further subdivided depending on the character, source, or category of partnership items, among other things, to allow the IRS to make net adjustments according to applicable limitations and restrictions for such subgrouping.

Generally, the result of each grouping will be netted against each other and if positive, will result in a general imputed underpayment. However, the IRS may determine a specific imputed underpayment based on adjustments being allocated to one partner or group of partners based on the items or adjustments having similar characteristics, the group of partners sharing similar characteristics, or the partners having participated in the same or similar transactions. The option to provide multiple, targeted imputed underpayments is intended to allow the partners, partnerships and the IRS the flexibility to address fact-specific issues that may arise at the partnership level. For example, if partnership adjustments are made to both ordinary income which is allocated to all partners and capital gains which are allocated to a single partner, the Proposed Regulations allow for a general imputed underpayment with respect to the ordinary income adjustment and a specific imputed underpayment with respect to the capital gains adjustment.

The Proposed Regulations include a number of examples illustrating how imputed underpayments are calculated but, of course, how these rules will operate in practice as applied to the myriad of potential adjustments remains to be seen.

The Procedures for Modifying an Imputed Underpayment

In the event of an imputed underpayment, the applicable partners may file amended returns in lieu of the partnership paying the imputed underpayment. To the extent the one or more partners file amended returns and pay the associated tax, penalty, and interest, the imputed underpayment payable by the partnership may be correspondingly adjusted.

The partnership representative may request a modification to the imputed underpayment by seeking an alteration of the adjustment factors (e.g., because one or more partners amended their returns or a partner is a tax-exempt entity or qualified investment entity) or the tax rate used to calculate the amount of the imputed underpayment (e.g., with respect to capital gains of, or qualified dividends to, a C corporation or individual partner). Partners should seek the right in the partnership agreement to cause the partnership representative to request a modification to the imputed underpayment where appropriate and beneficial.

The Procedures for Electing an Alternative to Payment of the Imputed Underpayment

The Proposed Regulations provide guidance with respect to the Section 6226 Election, which allows a partnership to elect to have any imputed underpayment resulting from an audit adjustment to be paid by the partners rather than by the partnership. A Section 6226 Election must be made within 45 days of the IRS mailing a Final Partnership Adjustment and the election must include the name, address, and TIN of the partnership, the taxable year to which the election relates, the imputed underpayment(s) to which the election applies, the name, address, and correct TIN for each partner during the year of adjustment, and any other information required under the forms, instructions and guidance and be signed by the partnership representative. The partnership representative must also provide separate statements to each partner during the year to which an adjustment relates (a "reviewed year") of the partner's share of the partnership adjustments and any interests, penalties, additions to tax, or additional amounts and modifications for the reviewed year and any intervening year.

If a partnership makes a valid Section 6226 Election with respect to any imputed underpayment, the reviewed year partners must take into account their share of the partnership adjustments that relate to that imputed underpayment and will be liable for any associated tax, penalties, and interest. A reviewed year partner may either pay its share of the imputed underpayment using the calculation rules provided in the Proposed Regulations or pay the safe harbor amount (and interest). Under the Proposed Regulations, the calculation rules require the partners to pay the "correction amount" for the reviewed year—i.e., the amount of tax the partner would be required to pay if it had reported partnership items on its returns in the manner required by the partnership adjustment. Alternatively, if the partner elects to pay the safe harbor amount, the partner will essentially pay its share of the partnership imputed underpayment at the highest tax rate under Section 6225(b)(1)(A). Although the safe harbor amount allows the partner to avoid the potentially complex exercise of calculating the amount of tax due had the adjustment been accurately reported in the first instance, it may result in the partner paying an increased assessment as the safe harbor amount does not take into account potential decreases to tax and uses the highest rate of tax. Accordingly, partners should consider the costs and benefits of each approach. A reviewed year partner may also consider filing an amended return for the relevant years (and paying the necessary tax, penalties, and interest) in order to avoid paying amounts otherwise due as a result of the Section 6226 Election.

The Section 6226 Election is not without cost, however: if a Section 6226 Election is made, the interest rate imposed on the imputed underpayment will be 2 percent higher than if the imputed underpayment is paid by the partnership. This increased cost (as well as any increased administrative costs) should be taken into account in determining whether a Section 6226 Election should be made. Importantly, partners should seek consent rights over a partnership representative's ability to make a Section 6226 Election.

A Section 6226 Election does not preclude the partnership representative from challenging the Final Partnership Adjustment in court. If the partnership representative challenges the Final Partnership Adjustment, it is not required to send separate statements to the partners (and the partners are not required to pay their share of any adjustment) until the adjustments are finally determined. The partnership representative may also request to revoke a Section 6226 Election after challenging a Final Partnership Adjustment in court.

The Proposed Regulations reserve on the mechanics of a Section 6226 Election where a partner is a partnership or other pass through entity as well as the effect of adjustments on a partner's outside basis or capital account and the partnership's basis and book value of its property. The IRS and the Treasury request comments on both of these issues.

The Procedures and Requirements for an Audit Adjustment Request

A partnership representative may choose to file for an administrative adjustment (an "Administrative Adjustment Request" or "AAR") to correct errors on a partnership return for a prior year. An AAR may be filed with respect to one or more items of income, gain, loss, deduction, or credit of the partnership and any partner's distributive share thereof for any partnership taxable year for which a partnership return has been filed within three years from the later of the date the partnership return for such partnership taxable year was filed or the last day for filing such partnership return. Unless the IRS determines otherwise, the AAR, and each partner's share of the adjustment, is binding on each partner, and an AAR that results in an imputed underpayment must be paid by the partnership, unless the partnership elects to have the reviewed year partners take such adjustment into account.

Because only the partnership representative may file an AAR, as with other provisions noted here, partners should seek the right to request that the partnership representative file an AAR approved by them.