Beginning 2018, the IRS is authorized to collect from a partnership any tax deficiencies arising out of the partnership’s operations for a taxable year, even if the persons who were partners in the year to which the deficiency relates are no longer partners in the year that the deficiency is assessed.
Stated differently, the current-year partners will bear the economic burden of the tax liability even though the tax adjustments relate to a prior year in which the composition of the partnership may have been different.
How did we get to this, and what should partnerships and their partners be doing about it?
Bipartisan Budget Act of 2015
The number of partnerships and partners in the U.S. continues to increase, as do the total receipts and the value of total assets for all partnerships. LLCs classified as partnerships account for the majority of this growth. This development is a clear manifestation of the fact that the partnership represents the most flexible form of business entity.
As partnerships have grown in number, size, and complexity, the IRS has found it increasingly difficult to audit them and to collect any resulting income tax deficiencies, especially in the cases of large partnerships and tiered partnerships.
In response to these difficulties, Congress enacted the Bipartisan Budget Act of 2015 (the “BBA”), which added a number of new tax compliance provisions to the Code that become effective on January 1, 2018.
A key feature of the BBA is that it imposes liability for any audit adjustments with respect to an earlier partnership tax year on the partnership, rather than on those persons who were partners during the audited tax year.
Partnership Audits: Pre-2018
Prior to the BBA, two different regimes existed for auditing “closely-held” partnerships:
- For partnerships with ten or fewer partners, the IRS generally applied the audit procedures for individual taxpayers, auditing the partnership and each partner separately.
- For most large partnerships with more than ten partners, the IRS conducted a single administrative proceeding (under the so-called “TEFRA” rules, which were adopted in 1982) to resolve audit issues regarding partnership items that were more appropriately determined at the partnership level than at the partner level.
- Under the TEFRA rules, once the audit was completed and the resulting adjustments were determined, the IRS recalculated the tax liability of each partner in the partnership for the particular audit year.
New Default Rule: A “Taxable Partnership”
Under the BBA, the TEFRA rules are repealed, and the partnership audit rules are streamlined into a single set of rules for auditing partnerships and their partners at the partnership level.
Under the streamlined audit approach, the IRS will examine the partnership’s items of income, gain, loss, deduction, credit for a particular year of the partnership (the “reviewed year”).
However, the IRS is no longer required to determine each partner’s share of the adjustments made to these partnership items, followed by a separate computational adjustment for each partner, to assess the correct tax due as a result of the partnership audit.
Instead, under the new default rules, any adjustments to these tax-related items of the partnership for the reviewed year will be taken into account by, and the tax liabilities attributable to these adjustments (including interest and penalties) – the “imputed underpayment” – will be assessed against, and collected from, the partnership.
Thus, the economic burden thereof will be borne by the persons who are partners of the partnership during the taxable year that the audit (or any administrative or judicial review thereof) is completed (the “adjustment year”) – not by those persons who were partners during the year to which the adjustments relate.
Moreover, the tax resulting from such adjustments will be computed at the highest marginal rate for individuals or corporations (as the case may be) in the reviewed year, without regard to the character of the income or gain.
In order to facilitate the application of the new audit regime, the BBA requires the designation by each partnership of a partnership representative (the “PR”). The PR, who does not need to be partner of the partnership, shall have the sole authority to act on behalf of the partnership in tax matters, and the partnership and all partners shall be bound by any actions taken by the PR, including in settlement of an audit.
The foregoing marks an important change in the audit of closely-held partnerships.
In recognition of this fact, and in order to address certain inequities that may result therefrom, the BBA provides some relief.
Where the imputed underpayment calculation exceeds the amount of tax that would have been due had the partnership and the partners reported the partnership adjustments properly, a partnership (and its partners) will have the option of demonstrating that the adjustment would be lower if it were based on certain partner-level information from the reviewed year, and did not rely only on the partnership’s information for such year.
Thus, if one or more partners file amended returns for the reviewed year, such returns take into account the adjustments made by the IRS that are properly allocable to such partners, and payment of any tax due (calculated using the highest marginal rate of tax for the type of income and taxpayer) is included with the amended returns, the partnership’s imputed underpayment shall be determined without regard to the portion of the adjustments taken into account in the amended returns.
Small Partnership Election
The foregoing is not the only relief provided.
An eligible partnership is permitted to affirmatively elect out of the new audit regime, in which case the partnership and its partners will be audited under the pre-TEFRA audit procedures, under which the IRS must separately assess tax with respect to each partner under the deficiency procedures generally applicable to individual taxpayers.
In order to qualify for this “small partnership” election, the partnership must have 100 or fewer partners. A partnership satisfies this requirement when it is required to furnish 100 or fewer Schedule K-1s. For a partnership that has an “S” corporation as a partner, the number of Schedule K-1s that the S corporation is required to furnish to its shareholders is taken into account to determine the number of K-1s furnished by the partnership.
In addition, each partner of the partnership must be an individual, a “C” corporation, a foreign entity that would be treated as a “C” corporation if it were domestic, an “S” corporation, or the estate of a deceased partner. Thus, for example, another partnership, the estate of someone other than a deceased partner, and a trust cannot be partners of an electing small partnership.
It should also be noted that the election must be made on an annual basis, it must be made on a timely-filed partnership return (including extensions), and the partnership must notify the partners of the election.
Another Election Out?
A partnership that does not qualify for the small partnership election – or which does not elect to be treated as such – may still be able to elect out of the new audit regime.
It can do so by electing to have its reviewed-year partners take into account the adjustments made by the IRS, and pay any tax due as a result of those adjustments. In that case, the partnership will not be required to pay the imputed underpayment.
The electing partnership would pass the adjustments along to its reviewed-year partners by issuing adjusted Schedule K-1s to them. Those partners (and not the partnership) would then take the adjustments into account on their individual returns in the adjustment year through a simplified amended-return process.
A partnership must elect this alternative not later than 45 days after the date of the notice of a partnership adjustment (a “Sec. 6226 election”). Where the election is made, the reviewed-year partners will be subject to an increased interest charge as to any tax deficiency.
Because the BBA marks a significant change in the audit of partnerships, and because it applies to both existing and new partnerships, its effective date was delayed: the new rules will first become effective for returns filed for partnership tax years beginning after 2017.
In the case of a partnership with a taxable year that ends on December 31, that means the rules will become applicable on January 1, 2018 – only two months away.
The delayed effective date provided the IRS with time to prepare and issue proposed regulations to implement and interpret the statutory changes, which it did in June of this year; however, it is not clear when these will be issued in final form.
Amend Partnership Agreements
Partnerships were afforded plenty of time, between the 2015 passage of the BBA and its January 1, 2018 effective date, to consider the implications of the new audit regime.
That being said, there are still many partnerships out there that have not yet amended their partnership/operating agreements in response to these new rules. After all, the first partnership return that will be subject to the new rules, for the 2018 tax year, which will not be filed until March of 2019, and it will not be audited until a year or two later.
Nevertheless, partnerships should anticipate that they may admit new partners and lose old partners during the course of the 2018 tax year, and these persons will need to be aware of what their obligations will be insofar as 2018 tax liabilities are concerned.
Many partnerships will qualify, and will likely elect to be treated, as a small partnership.
However, many partnerships will not qualify for this election because they include “ineligible” partners, such as trusts or other partnerships.
These partnerships, or their partners, may want to consider a change in their ownership structure so as to qualify for the election; for example, by dissolving trust-partners, causing their partnership interests to be distributed to individual beneficiaries. (Of course, this first has to make sense from a business and familial perspective.)
Other partnerships will lose their qualification upon the admission of such a partner (for example, a partnership-investor). Still others will forget to make the annual election, and, so, will fall within the scope of the new rules.
Therefore, no partnership can assume that the new audit rules will not apply to it and, so, every partnership has to ensure that its partnership/operating agreement addresses the new rules.
Among the items for which the agreement should be amended are the following:
- if the partnership believes it will qualify as a small partnership, it may require that the election be made;
- it may also want to restrict the transfer of its partners’ partnership interests so as to ensure its continued qualification;
- if the partnership does not qualify for, or fails to elect as, a small partnership, it may require that the Sec. 6226 election be made, under which the reviewed-year partners (including former partners) will amend their returns for such year to account for any audit adjustments and satisfy the resulting liability;
- require reviewed-year partners (including former partners) to provide such information as may be necessary to reduce the tax liability for the reviewed year;
- require reviewed-year partners (including former partners) to indemnify the partnership and the adjustment-year partners for any liability attributable to the reviewed year;
- provide for the selection and removal of the PR;
- require the PR to inform the partners of any audit, keep them abreast of the audit’s progress, including proposed adjustments;
- limit the PR’s ability to settle an audit without the consent of the partners;
- address reviewed year tax liabilities of the partners following the dissolution of the partnership.
The foregoing considerations may be especially important to transferees of partnership interests (whether acquired by gift or purchase, as compensation, by distribution or otherwise), and to potential new investors.
Before acquiring an interest, these new or potential partners are likely to insist upon increased levels of due diligence of the partner’s tax returns and related documents. They will also insist upon protection against losses that may be incurred for prior year partnership tax liabilities.
The foregoing has assumed the existence of a partnership. What if the parties that are coming together to conduct business are not “formal” members of a partnership? Such persons must first determine whether their arrangement constitutes a partnership for tax purposes. This may not be an easy task, and there are no assurances that the IRS will agree with the parties’ conclusion.
What, then, can such persons do? Bite the bullet, concede they are partners, file partnership returns, and adopt a partnership agreement with the above-described safeguards? Or wait for the IRS to determine their status and, at that point, make a Sec. 6226 election?
These are new rules. Eventually, “final” regulations will be issued. At some point, the courts will interpret the new rules, and the IRS will apply its regulations. Their collective experience will inform taxpayer’s actions.
Until then, it’s best to approach the new rules as conservatively as possible, while at all times preserving the business arrangement among the parties, and maintaining enough flexibility to respond to future changes.