New Rules Adopted for IRS Partnership Tax Audits

The Bipartisan Budget Act of 2015 signed by the President Obama on November 2, 2015, creates a new IRS audit regime for all entities treated as partnerships for federal income tax purposes, including partnerships and limited liability companies (“partnerships”).^[1]

Under current rules, except for certain small partnerships, the IRS conducts audits of partnership items of income, gain, deduction, loss and credit at the partnership level, but any assessments of tax are made at the partner level. The partnership is not liable for taxes on any audit adjustments; instead, the partners of the partnership for the audited years owe the taxes on the adjustments. The new rules change this.

Under the new rules, subject to the elect-out option discussed below, the IRS still audits at the partnership level. But if the IRS determines the partnership has understated income or overstated losses, the partnership, as opposed to the partners, would owe any tax, interest, and penalty, due in the year the audit is finalized. Since the tax is owed by the partnership, the IRS will not have to track down the persons who were partners for the years that were audited. 

The IRS determines the tax the partnership owes based on the highest applicable rates for individual or corporate partners. The IRS is authorized to provide rules for making certain adjustments, including reductions for income allocable to tax-exempt organizations that would not owe tax, and for lower rates on capital gains and dividends. The burden will be on the partnership to demonstrate, before the IRS issues a final assessment, that it is entitled to such adjustments, which may prove difficult in the case of a partnership with numerous indirect partners. Interestingly, partnerships are not entitled to refunds; instead, the partners must file timely refund claims after the IRS determines the right to a refund at the partnership level.

The provisions typically found in current agreements addressing the designation of a “tax matters partner” and attendant obligations and powers are obsoleted by the new rules, under which a partnership will name a “partnership representative” to represent and bind it in connection with IRS audits. These rules are effective for partnership tax returns filed for partnership tax years beginning after December 31, 2017 (unless the partnership elects to have these rules apply earlier). Agreements entered into after November 2, 2015, should include provisions addressing the new rules.

There are three means by which a partnership will be able to avoid paying all or some of the tax assessed by the IRS:

1. Certain small partnerships (those with less than 100 partners and only certain types of partners) may elect out of the new rules altogether. Importantly, a partnership cannot elect out of the new rules if it has a partnership as a partner. If a partnership is eligible to elect out of the new rules and does so, it will not be subject to the partnership-level audit rules—any audit adjustments will be made with respect to one or more of the partners and any tax assessed would be assessed only against the audited partners;
2. If a partnership is subject to these new rules (because it is not eligible to or did not elect out), the partnership will be audited at the partnership level but will not be liable for tax on audit adjustments to the extent that the partners in the reviewed years timely file amended returns for the audited years, including the audit adjustments on such amended returns, and pay the tax due on such adjustments; or
3. If a partnership is subject to these new rules (because it is not eligible to or did not elect out), the partnership will be audited at the partnership level, but if the partnership properly and timely elects to cause the partners to include the adjustments in the year of the adjustment, not the tax year(s) under audit, the partnership will not be liable for the tax. If a partnership elects this option, each partner will determine tax owed through a complicated process taking into account the additional tax that would have been due in the audited year and all intervening years before the year of the final adjustment by the IRS, and the partners would owe interest on any underpayment at a 2 percent higher rate than would the partnership for an underpayment determined at the partnership level.

Our initial thoughts are that most partnerships will not want to pay the tax themselves—they will want the partners to pay the tax (especially if there have been any transfers, issuances or redemptions of partnership interests between the years that are audited and the year in which the tax must be paid). Partners not expecting to incur legal and accounting costs in connection with a passive investment in a partnership may view this issue differently.

There are many unresolved issues and unanswered questions about the new rules. We will keep you informed as guidance is issued.

Takeaways:

1. Partnership agreements should reflect the new rules, including the desired elections and designation of the partnership representative.
2. Tax distribution provisions should be reviewed to make sure they are consistent with the elections made by the partnership.
3. Consider how a partnership subject to the new rules will get the money to pay expenses of defending against the audit and any tax, interest, and penalty that may be due.
4. In a transaction where a buyer is acquiring a partnership interest, the buyer should consider protecting itself from bearing the economic costs of the seller’s taxes. Partnerships should similarly consider the interests of continuing partners in cases where they effect complete redemptions of a partner's interest.
5. Partnership agreements should include indemnification provisions for the partnership representative and the partners to try to assure that any audit-assessed taxes are borne by the appropriate partners.
6. Partners that want to participate in the selection of the partnership representative, the audit process, any litigation, and approval of any settlement the partnership reaches with the IRS should negotiate to include such provisions in the partnership agreement.

Please click here to see a decision tree showing, in general, how these new rules will apply.

[1]  A domestic limited liability company (LLC) with two or more regarded members is treated as a partnership for federal income tax purposes, absent an election to be treated as a corporation. A domestic LLC with a single regarded owner is a disregarded entity, unless it elects to be treated as a corporation. (An entity formed as a partnership also can be a disregarded entity if it is wholly owned, directly or indirectly, by a regarded taxpayer and other disregarded entities owned by that taxpayer.) A disregarded entity is not a partnership for purposes of the new partnership audit rules.