The Bipartisan Budget Act will allow the IRS to collect taxes associated with audit adjustments at the partnership level, rather than passing adjustments through to the individual partners, effectively imposing entity-level tax on partnerships themselves.
The recently enacted Bipartisan Budget Act of 2015 (H.R. 1315) is set to overhaul how the Internal Revenue Service (IRS) audits and collects tax from partnerships.
The new law repeals the partnership audit rules of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) and the electing large partnership rules. The new legislation will allow the IRS to collect taxes associated with audit adjustments at the partnership level, rather than passing adjustments through to the individual partners. The Bipartisan Budget Act effectively imposes entity-level tax on partnerships themselves.
Although the new law will not go into effect until January 1, 2018, partnerships will undoubtedly feel its repercussions much sooner. It may have a significant impact on how partnership interests are valued, transferred and protected. Partnerships and partners should start planning early to ensure their interests are protected.
The new partnership audit regime applies to all partnerships, regardless of size. Partnerships with 100 or fewer partners may elect out of the new audit rules only if the partners are individuals, C corporations, foreign entities that would be treated as C corporations were they domestic, S corporations, or estates of deceased partners (Small Partnerships). If any partner is another partnership or a trust, the partnership may not elect out. Further, if a partner in the partnership is an S corporation, each of the S corporation’s shareholders is treated as a partner of the partnership for the purposes of determining whether the partnership has 100 or fewer partners.
Even if a Small Partnership meets the eligibility criteria for electing out of the new audit rules, the opt-out process is burdensome and requires the following:
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The Small Partnership must elect the opt-out on its partnership return each year.
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The Small Partnership must inform each of its partners of the election.
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The Small Partnership must submit the names and taxpayer identification numbers of each of its partners, including S corporation shareholders treated as partners, to the IRS.
Entity-Level Tax
Rather than assessing individual partners, the IRS will assess the partnership for "imputed underpayment," which will be subject to the individual or the corporate tax rate. However, the law allows the IRS and the Department of the Treasury to implement rules that could adjust this rate if a partnership can prove that certain partners are subject to a lower tax rate.
The new law requires the IRS to assess the partnership in the year of adjustment, rather than the year under audit. Thus, it is possible for current partners to be liable for tax reporting that benefited former partners.
To compensate for this possibility, the new law allows for two possible exceptions that can transfer partnership-level tax liabilities back to prior-tax-year partners.
Exception 1
If a partner pays what is owed based on partnership-level adjustments, the partnership’s imputed underpayment is reduced accordingly. To take advantage of this exception, persons who were partners for the year under audit, the reviewed year, must file amended tax returns reporting their distributive shares of partnership adjustments and pay all applicable taxes within 270 days of receiving notice of a proposed partnership adjustment. This exception may be difficult to meet, as it requires the partnership to:
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Assess the effects of a series of proposed adjustments.
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Provide conforming statements of adjustment to each partner.
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Persuade the partners, including former partners, to file amended tax returns and applicable payments reflecting the newly issued K-1s, including years indirectly affected by the K-1s.
Exception 2
The second exception requires very prompt action from the partnership. Within 45 days of getting a final notice of a partnership adjustment, the partnership is permitted to elect to issue statements to the partners who were partners during the reviewed year reflecting the distributive share of partnership items as adjusted by the IRS (essentially, issue-amended K-1s for the reviewed year). If this election is made, the partners pay tax in the year that the revised statement (K-1) is issued, but they are charged interest on the underpayment of tax from the year of the adjustment at a rate equal to the "hot interest rate" set forth in Internal Revenue Code section 6621(c).
Partnership Representative
The new law requires partnerships to appoint a person or entity with substantial presence in the United States to serve as the partnership’s representative (PR) before the IRS. The PR has the sole authority to act on behalf of the partnership. If the PR is a trust, estate, partnership, association, company or corporation, a responsible person, such as a corporate officer, partner or trustee, must act on behalf of the PR. If a partnership fails to appoint a representative, the IRS is authorized to appoint the PR.
Impact on Partnership Governance and Partnership Agreements
In light of the new audit regime, partnerships should consider including the following in their partnership agreements:
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Rules for electing a PR and restrictions on actions that may be taken by the PR.
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Rules requiring the partnership to notify the partners when an IRS audit commences and to keep them informed about the progress of the audit and any proposed IRS adjustments.
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Information about whether the partnership agreement requires an election out of the entity-level assessment.
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Escrow and indemnification provisions for when partners sell their interests.
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Opt-out provisions for qualifying small partnerships.
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Provisions regarding partner-amended returns.
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Information-sharing provisions to allow partnerships to determine if the ultimate owners are:
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Corporations
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Individuals entitled to lower capital gain and dividend tax rates
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Tax-exempt entities.
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Allocation of tax payments.
The Bipartisan Budget Act will have deep consequences regarding tax planning for partnerships. It is essential to work with a knowledgeable tax attorney to develop optimal strategies that take into account the new audit rules.
