The recently
enacted Bipartisan Budget Act of 2015 amended existing Internal Revenue Code of
1986, as amended (the “Code”) rules governing tax audits of partnerships in the
U.S. These new rules primarily impact partnerships with more than 100 partners
and will generally apply to partnership taxable years beginning after December
31, 2017.
A partnership may elect to apply the new rules to tax returns for
partnership taxable years beginning after November 2, 2015 and before January
1, 2018. Certain partnerships with 100 (or fewer) partners may opt to elect out
of the new rules and instead be subject to audits at the partner level.
Current Partnership Audit Rules
Currently,
partnership audits are conducted under three different regimes depending on the
number of partners in the audited partnership. Audits of partnerships with 10
or fewer partners are conducted at the partner level together with audits of a
partner’s individual return. A partnership with 10 or more partners is audited
at the partnership level, with any resulting adjustments resulting in
redeterminations of the partners’ individual tax liabilities (and amended
Schedules K-1 and partner tax returns) for the audited year(s).
Finally, for a
partnership with 100 or more partners that elects to be treated as an “electing
large partnership,” any adjustments resulting from an audit of the partnership
are generally taken into account by the partners on a current basis (i.e., in the
year the audit is concluded), without adjusting any prior year returns relating
back to the audited tax year.
New Audit Rules
The
new rules replace the existing partnership audit regimes with a general regime
and two noteworthy elective options. Under the general regime, audits of a
partnership’s items of income, gain, loss, deduction or credit (including the
partners’ distributive shares of those items) will occur at the partnership
level, in a manner similar to the existing regime for electing large
partnerships.
Any adjustments will generally be taken into account by the
partnership, instead of the individual partners, in the year in which the audit
is concluded. In addition, any additional tax liability attributable to the
adjustments will be assessed and collected (together with any penalties and
interest) from the partnership based on an assumption that the highest applicable
tax rate should apply. A partnership under audit will have the option to submit
partner-level information relating to the year under audit (for example,
amended partner returns, applicable tax rates applicable to certain partners or
income allocated to those partners) to support a reduced adjustment.
While such
information may reduce the resulting partnership liability, it will not alter
the requirement that the partnership bear such liability in the year in which
the audit is concluded. As a result, persons who are partners during the year
the audit is concluded will bear (indirectly) any additional tax liability
attributable to the audit adjustments, irrespective of their interests (if any)
in the partnership during the year under audit.
Partnership Representative
The
new legislation will also replace the existing “tax matters partner”
designation rules with a “partnership representative” concept. Going forward,
the partnership representative will have sole authority to act on behalf of the
partnership with respect to audits and partnership reviews. Future regulations
will address the manner in which a partnership representative shall be
designated, but it appears that the eligibility requirements will be more
flexible than those currently applicable to tax matters partner designations.
As amended, the statute will merely require that the partnership representative
be “a partner (or other person) with a substantial presence in the United
States.” Thus, the statute raises the possibility of designating a partnership
representative who is not a partner in the partnership.
Observation: Although future regulations will
likely further clarify the eligibility requirements for partnership
representatives, the ability to designate a person other than a “general partner”
or “managing member” (as is currently required when designating a tax matters
partner) would be a welcome development. In particular, such flexibility would
alleviate the uncertainty that arises when designating tax matters partners for
“check-the-box” partnerships, as well as the difficulties faced by partnership
sponsors that, for regulatory reasons, may be unable to act as general partners
or managing members.
On the other hand, it is unclear how the requirement that
the partnership representative have “a substantial presence in the United
States” will impact partnerships that have non-U.S. general partners or
managing members who currently act as tax matters partners.
Election Out of Audit Regime for Certain Smaller
Partnerships
Certain
partnerships with 100 or fewer partners may opt out of the new general audit
regime by making an affirmative election for each taxable year for which the
partnership seeks to opt out of the new rules. Although similar to the existing
regime for partnerships with 10 or fewer partners, additional conditions apply.
Specifically,
a partnership is eligible to elect out if:
the
partnership is required to furnish 100 or fewer statements under Section
6031(b) (i.e., Schedules K-1); and
its
partners consist solely of individuals, C-corporations, S-corporations, foreign
entities that, if domestic entities, would be treated as C-corporations, and
estates of deceased partners.
If
an eligible partnership makes this election, certain procedural issues relating
to an audit would need to be addressed directly by each individual partner. For
example, the partnership would not be able to settle any audits on behalf of
its partners and, instead, any settlement agreements or extensions of the statute
of limitations must be agreed between each partner and the IRS.
Observation: Notably, the presence of a partner
that is itself a partnership (or a trust) will cause a partnership to become
ineligible for this election. Presumably, the drafters of the legislation were
concerned that tiered partnership (or trust-partnership) structures could
circumvent the 100-partner limit, although this could have been addressed with
a look-through rule.
Commonly used partnership vehicles that will be ineligible
for this election include master funds having partnership feeder funds, pooled
trading vehicles that have investing partnerships, and investment partnerships
that serve as investment options for certain funds of funds.
Election Out of Current Year Liability
The
new rules permit a partnership to opt of bearing current year liability for any
additional tax liabilities associated with audit adjustments relating to prior
audited years. The partnership must make such an election within 45 days of a
final adjustment. The election would result in such tax liabilities being borne
by the persons who were partners during the year under audit, rather than the
year in which the audit was concluded.
A
partnership that elects this option would furnish to each person who was a
partner during the year under audit a statement of the partner’s share of the
final partnership adjustment. Each such partner would reflect its portion of
the adjustment amount (including any associated penalties and interest) in its
current year tax return. As a result, any additional tax liabilities would be
allocated more fairly among those persons who were partners during the audited
year, while still avoiding any requirement for the partnership or those
partners to amend prior year Schedules K-1 or partner tax returns.
It
should be noted, however, that this more streamlined approach comes at the cost
of a higher interest charge. In general, the rate of interest on underpayments
of tax is determined by increasing the federal short-term rate by three
percent. Under this election, however, interest is charged at the federal
short-term rate plus five percent.
Observation: The availability of this option, which
eliminates current year partnership liability without requiring amended
Schedules K-1 or partner tax returns (albeit at the cost of increased interest
rates), would appear to be the favored choice for any partnership not otherwise
eligible to opt out of the general partnership audit regime entirely by making
the election available for certain smaller partnerships (described above).
Subject to forthcoming regulatory clarifications, this option also seems
preferable to the partnership audit regimes currently applicable to
partnerships having more than 10 partners.
Practical
Considerations / Market Practice
For
purposes of the new partnership audit rules, a “partnership” is defined broadly
to include any entity treated as such for U.S. federal income tax purposes
(including entities that elect to be treated as partnerships under the
so-called “check-the-box” rules). Accordingly, these new audit rules
potentially will affect any partnerships that file U.S. partnership returns,
including U.S. partnerships (and limited liability companies treated as
partnerships) and most non-U.S. partnerships with U.S. partners (either
directly or indirectly through one or more tax transparent entities).
While
we expect that forthcoming regulations will contain more detailed guidance
(particularly in respect of the election to opt out of current year partnership
liability), a few steps should be taken now.
Operating
agreements of existing partnerships should be updated to address how
partnership audits will be handled once the new rules become effective, such as
who will designate (or be designated as) the partnership representative. In
addition, consideration should be given to whether the partnership
representative will be given broad authority to make all available elections
(for example, electing out of the new audit rules or electing out of current
year partnership liability). In the event that neither such election is made, a
partnership may consider allocating to audit year partners, or “clawing back”
from such partners, any resulting current year tax liability that is borne by
the partnership.
The partnership may also consider imposing indemnification
obligations on withdrawing partners. For affected partnerships that are fund
vehicles, offering documents should contain updated disclosures reflecting the
new partnership audit rules. Some partnerships may wish to develop a definitive
stance on whether to make any available elections prior to admitting partners
or entering into any investor side letter negotiations.
The
discussion above highlights only some of the issues confronting partnerships
and their partners with respect to the new partnership audit rules. Although
many aspects of the new rules require further clarification, what is clear is
that these rules will significantly change the administration of partnership
audits. Although these changes generally will not take effect until after
December 31, 2017, however, partnerships and their partners should start
preparing now.
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