Tax Alert: Partnership audit rules revised under 2015 budget actBy Mark R. Baran | January 25, 2016 | Download PDF
The Bipartisan Budget Act of 2015, signed into law on November 2, 2015, raises the federal debt ceiling and lifts mandatory spending caps on defense and domestic programs. The law also makes sweeping changes to the rules for auditing partnerships. The end result of the revised rules is that audits of master limited partnerships, investment funds and other business entities organized as partnerships are likely to increase. More importantly, given the significant operational impact of the new audit rules, many partnership agreements will need to be reviewed and amended. The new rules are generally effective for partnership tax years beginning after December 31, 2017 but partnerships may elect to be governed by the new audit rules for any tax year for any tax year beginning on or after November 2, 2015.
Under previous law, partnerships could be audited under three regimes:
1. Unified audit rules. Under the Tax Equity and Fiscal Responsibility Act (TEFRA) unified partnership audit rules, the tax treatment of any partnership item generally is determined at the partnership level. For most partnerships with more than 10 partners, the IRS conducts a single administrative proceeding to resolve audit issues regarding partnership items that are more appropriately determined at the partnership level than at the partner level. After the audit is completed and the resulting adjustments are determined, the IRS recalculates the tax liability of each partner in the partnership for the particular audit year.
While a single administrative proceeding can resolve an issue with respect to all partners, the IRS must still assess any resulting adjustment against each of the taxpayers who were partners in the year in which the misstatement of tax liability arose. Partners may request an administrative adjustment or a refund for his or her own separate tax liability and participate in partnership-level administrative proceedings.
2. Small partnership rules. The TEFRA unified audit rules described above do not apply to partnerships having 10 or fewer partners (“small partnerships”). Each partner in a small partnership must be an individual (other than a nonresident alien), a C corporation or an estate of a deceased partner. These small partnerships may elect to have the unified audit rules apply. For small partnerships that do not make this election, the IRS generally applies the audit procedures applicable to individual taxpayers.
3. Electing large partnership (“ELP”) rules. Simplified audit procedures apply to large partnerships with 100 or more partners who elect to be treated as ELPs for reporting and audit purposes. Under these procedures, the IRS generally makes adjustments at the partnership level that flow through to the partners for the year in which the adjustment takes effect.
The current-year partners’ shares of current-year partnership items of income, gains, losses, deductions or credits are adjusted to reflect partnership adjustments that take effect in that year. Adjustments generally will not affect prior-year returns of any partners (except in the case of changes to any partner’s distributive shares). A partner in an ELP may not treat partnership items on their individual tax return inconsistently with the partnership return, even if the affected partner notifies the IRS of the inconsistency.
The revised rules
Federal tax authorities have long complained that the TEFRA rules made it difficult to audit partnerships, particularly complex structures with numerous partners. Under the TEFRA unified partnership audit rules, unless a partnership elects to be taxed at the entity level, the IRS is required to pass audit adjustments through to the ultimate partners. It has been argued that the operational costs associated with enforcement of this regime where a majority of partnerships do not elect to be treated at the entity level limits the number of partnership audits the IRS can conduct. The changes are expected to make it easier for the IRS to audit large partnerships.
The budget act repealed the current TEFRA unified partnership audit rules and the ELP rules, and replaced them with a streamlined single set of rules for auditing partnerships and their partners (and assessing and collecting any tax attributable to adjustments made in an audit) at the partnership level. Therefore, under the new streamlined audit approach, any adjustment to items of income, gain, loss, deduction or credit of a partnership for a partnership tax year (and any partner’s distributive share of such adjustment) is determined at the partnership level. Similarly, any tax attributable to such adjustment is assessed and collected (including penalties, additions to tax or additional amounts that relate to an adjustment to any such item or share) at the partnership level.
The new rules generally apply to partnership tax years that begin after December 31, 2017. However, except for the opt-out rules for small partnerships (discussed below), partnerships may elect to have the new law apply to any partnership return filed for partnership tax years beginning after November 2, 2015, and before January 1, 2018.
New audit process
The IRS will examine the partnership’s items of income, gain, loss, deduction or credit and partners’ distributive shares for a particular year of the partnership (termed the “reviewed year”). Any adjustments will be taken into account by the partnership (and not the individual partner) in the “adjustment year” (the year in which the audit or any judicial review is completed) and collected at the partnership-level unless the partnership elects to pass these adjustments to its partners.
Partnerships must pay tax equal to the “imputed underpayment,” which is defined generally as the net of all adjustments for any reviewed year multiplied by the highest individual or corporate tax rate. However, the imputed underpayment may be modified if a partnership shows that a lower amount is appropriate based on certain partner-level information. The IRS is directed to establish procedures to make such modifications where:
- A partner files an amended return for the partner’s tax year covering a period through the end of the reviewed year of the partnership, and the amended return takes account of the partnership adjustments including payment of the taxes due,
- The partnership shows that a part of the imputed underpayment is allocable to a partner that would not owe tax because it’s a tax-exempt entity, or
- The partnership shows that a part of the imputed underpayment is allocable to a partner that:
- In the case of ordinary income, is a C corporation, or
- In the case of a capital gain or qualified dividend, is an individual.
Any materials required to be submitted to the IRS with respect to decreased imputed underpayments must be submitted no later than the close of the 270-day period beginning on the date on which the notice of a proposed partnership adjustment is mailed, unless the IRS consents to an extension.
Additional aspects of the revised rules include:
Partner-level adjustment alternative. As an alternative to taking the adjustment into account at the partnership level, a partnership may make an election - not later than 45 days after a notice of final partnership adjustment - to issue adjusted information returns to the reviewed-year partners. If this election is made, the partners take the adjustment into account on their individual returns in the adjustment year through a simplified amended-return process. The election must be made in the time and manner prescribed by the IRS and can be revoked only with the IRS’s consent.
Administrative adjustment alternative. A partnership also has the option of requesting an administrative adjustment for a reviewed year, such as when it believes additional payment is due or an overpayment was made, with the adjustment taken into account in the adjustment year. The partnership generally would be allowed to take the adjustment into account at the partnership level or issue adjusted information returns to each reviewed-year partner.
Administrative adjustment requests may not be filed more than three years after the later of:
- The date on which the partnership return for such year is filed, or
- The partnership return due date for that year (determined without regard to extensions).
Consistency requirement. Under the “consistency requirement,” the partner must generally treat on the partner’s return each item of income, gain, loss, deduction or credit attributable to a partnership in a manner that is consistent with the treatment of the income, gain, loss, deduction or credit on the partnership return. Any underpayments attributable failure to comply with the consistency rules will be treated as a mathematical or clerical error and, unless the affected partner files an appropriate notification, will be immediately collectible without a notice of deficiency.
Small partnerships’ election to opt-out of new rules. Similar to the TEFRA rule excluding partnerships with 10 or fewer partners, partnerships with 100 or fewer qualifying partners may opt-out of the new rules for any tax year. Each partner must be an individual, a C corporation, a foreign entity that would be a C corporation under U.S. law, an S corporation or an estate of a deceased partner. Small partnerships who are eligible and opt out will be audited under the general rules applicable to individuals.
Impact on partnership agreements
Businesses and practitioners that are organized as or represent partnerships should become familiar with these important revised partnership audit rules. The delayed effective date was designed to allow sufficient time for the IRS to issue additional guidance on these new rules or allow time for Congress to provide further clarifications in the form of technical corrections that cannot otherwise be resolved administratively. However, since the new changes are a major shift from previous partnership audit practices, we recommend that clients review and consider amending existing partnership and limited liability company (“LLC”) agreements, and modify future agreements in order to be prepared when the new partnership audit rules take effect. Listed below are potential (though not exclusive) issues that should be considered when revising partnership or LLC agreements:
- Ensuring that the small partnership election to opt out is available and protected whether or not the partnership makes the election. For example, provisions may impose restrictions on the number and types of partners.
- Details concerning the specific duties, authority and appointment of the partnership representative.
- Procedures that determine partner assumption of tax liabilities, especially for liabilities that are assessed during the adjustment year. Consideration should be given to the impact on new partners, procedures that allow a partnership to issue amended K-1s to those who were partners during the review year (as opposed to the adjustment year), the impact on section 704(b) allocations, and indemnities.
- How tax payments made by the partnership will be processed and collected from partners (i.e., payment or distribution offsets, holdbacks).
- Whether and to what extent an acquired partnership is considered a continuation of the partnership for tax purposes.
The impact of the new partnership audit regime will be significant for a majority of partnerships in areas ranging from tax matters, operations, legal issues and economic consequences. Many unanswered questions and details remain unresolved, and further guidance and technical corrections may be needed to clarify certain provisions. In the meantime, partnerships, partners and advisors should remain informed, prepared and plan accordingly. Contact Marks Paneth LLP tax experts to learn more or answer any questions.
For more information
If you have questions about this alert, please contact Mark Baran, Principal in the Tax Practice, by phone at (212) 503-8991 or by email at email@example.com or any of our Marks Paneth professionals.
About Mark R. Baran
Mark Baran, JD LL.M., is a Principal in the Tax Department at Marks Paneth LLP. He has more than 25 years of specialized tax, transactional and legal experience advising publicly-traded and private companies, regulated financial institutions, investors, high net worth individuals, and government agencies. Mr. Baran provides specialized tax consulting and transactional services to a broad spectrum of clients and industries including the public sector. He routinely provides tax opinions on the tax implications of... READ MORE +