Partnership Audit Reform: New Partnership-Level Tax Impacts Certain Partnerships, LLCs and REMICs
The Bipartisan Budget Act of 2015 (the Budget Act), which was signed into law on November 2, 2015, has dramatically reformed how the U.S. Internal Revenue Service (IRS) will assess and collect taxes from partnerships, including limited liability companies (LLCs) treated as partnerships for tax purposes. The new partnership audit procedures enacted under the Budget Act (the New Audit Rules) provide that a tax adjustment resulting from a partnership audit generally will be determined at the partnership level, unless the partnership makes an election to have partners assume the audit tax liability. Accordingly, absent the exercise of an election as described below, the New Audit Rules can result in the imposition of an entity-level tax on the partnership as a result of audit adjustments. This heralds a significant change from the existing partnership audit procedures, under which the IRS generally makes audit adjustments at the partnership level but then is required to recalculate the tax liability of each partner in the partnership for the year under audit. The New Audit Rules are intended to alleviate the administrative difficulty much bemoaned by the IRS in determining the tax owed at the partner level, especially with respect to large and multi-tiered partnerships. Note also that because the existing rules, in certain instances, treat "real estate mortgage investment conduits" (REMICs), vehicles used in mortgage securitization transactions, as partnerships, the new rules may impact these entities as well.
Existing Partnership Audit Regime
Under currently effective law:
- Partnerships with more than 10 partners are subject to audit provisions that were enacted under the "Tax Equity and Fiscal Responsibility Act of 1982" (TEFRA). The TEFRA rules established a unified audit procedure that the IRS administers at the partnership level, after which the IRS must assess any resulting tax adjustment against each partner individually with respect to the year under audit. A TEFRA partnership designates one of its partners as the "tax matters partner" (TMP) to act on behalf of the partnership in administrative and judicial proceedings, although other partners may be entitled to exercise certain participation rights.
- Partnerships with more than 100 partners may elect to be subject to special "electing large partnership" (ELP) rules. The ELP regime is a simplified version of the TEFRA regime, except that under the ELP rules any tax adjustment is taken into account by those partners who are partners in the year the adjustment takes effect (as opposed to the prior year under audit).
- Certain small partnerships with 10 or fewer partners are exempt from the TEFRA regime and are instead subject to the audit procedures that otherwise apply to individual taxpayers.
- REMICs with a single equity (or "residual interest") holder are exempt from the TEFRA regime.
Effective Date of the New Audit Rules
The New Audit Rules will be effective for partnership returns filed for tax years commencing on or after January 1, 2018 (the Effective Date), although a partnership may elect to be subject to the New Audit Rules before that date. Given potential complications with the new rules, as discussed further herein, it appears that many partnerships would not choose that path.
Scope of the New Audit Rules
The New Audit Rules will apply to all partnerships, irrespective of size and whether the partnership was formed prior to the Effective Date. However, certain partnerships with 100 or fewer partners during a tax year may elect out of the New Audit Rules with respect to that tax year (the Election-Out), provided that each of those partners is one of the following: An individual, a C corporation (or a non-U.S. entity that would be treated as a C corporation if it were a U.S. entity), an S corporation, or an estate of a deceased partner (collectively, the Qualifying Partners). Presumably, therefore, any partnership that has a partner that is itself a partnership cannot opt out of the New Audit Rules. The Budget Act also grants the U.S. Treasury Department the authority to prescribe special rules for partners that are not included in the statutory list of Qualifying Partners, and, accordingly, it is likely that the category of Qualifying Partners may be expanded, at least modestly, in the future. Thus, for example, real estate investment trusts (REITs) and regulated investment companies (RICs), although not specifically identified in the statute as Qualifying Partners, may be classified under future regulations as Qualifying Partners, in that, like S corporations, they must qualify as corporate entities for tax purposes, albeit that they are not subject to full entity-level tax.
Ultimately, because the Election-Out requirements must be retested annually, partners and partnerships that desire to remain outside of the New Audit Rules will need to monitor closely the number and character of any incoming partners admitted during each tax year. In addition, as noted above, the Election-Out generally will be unavailable to tiered partnership structures.
Although not explicitly stipulated in the New Audit Rules, if a partnership successfully elects out of the New Audit Rules and the IRS thereafter makes an audit adjustment, the IRS presumably is required to follow the audit procedures that otherwise apply to individual taxpayers and issue a separate audit report to each partner.
General Rule: Partnership-Level Audit Determinations
Unless an exception applies, the New Audit Rules provide that any adjustment to items of partnership income, gain, loss, deduction, or credit, and any adjustment to a partner's distributive share thereof, are determined at the partnership level. If a tax deficiency arises from a partnership-level adjustment with respect to the year under audit (the Reviewed Year), then the IRS will assess and collect that tax deficiency from the partnership in the year that the audit (or any judicial review) is concluded (the Adjustment Year). The tax deficiency is calculated by netting all adjustments of income, gain, loss, or deduction and multiplying that net amount by the highest statutory income tax rate in effect in the Reviewed Year for either individuals or corporations. Furthermore, the partnership is directly liable for any applicable penalties and interest.
Note that because the New Audit Rules require the IRS to assess and collect tax from the partnership in the Adjustment Year, as opposed to the Reviewed Year, current-year partners may indirectly (and undesirably) bear the burden of any tax liability arising from erroneous tax benefits claimed by prior-year partners. This may well lead to negotiations in contracts for sales of partnership interests over appropriate tax covenants and indemnities, similar to what happens currently in the case of stock purchases and sales. (Although this can occur even under currently effective law, as a practical matter it is less of an issue as this situation arises only with ELPs, as noted above.)
Exceptions to the General Rule
The above-described general rule may be mitigated in two ways:
1. Procedures to Reduce Partnership Liability
The tax deficiency imposed on a partnership may be reduced in one of two ways: First, a partnership may provide certain partner-level information to the IRS, indicating that the tax deficiency calculated with respect to the Reviewed Year should be lower than that asserted. Such information may pertain to the tax rates applicable to, or status of, particular partners (e.g., individuals, corporations, or tax-exempt entities) or to the treatment of particular items related to the audit adjustment (e.g., capital gains or qualified dividends). Although on the face of the legislation, other partner-level information (such as the existence of net operating losses) is not taken into account for these purposes, the Budget Act authorizes the U.S. Treasury Department to determine the final scope of partner-level characteristics that may be reported to reduce the tax deficiency. Accordingly, the regulations may well broaden the scope of items permitted to be taken into account for this purpose.
Second, if any partner files an amended tax return for the Reviewed Year that reflects all partnership-level audit adjustments properly allocable to that partner and pays the resulting additional tax that is due, then the partnership may reduce its entity-level tax deficiency by the amount of such additional tax paid by that partner.
These two procedures to reduce the partnership-level tax deficiency may prove impractical or excessively burdensome to implement. Reporting partner-level information to the IRS may be difficult to administer, especially in the case of tiered partnerships where the ultimate partners may be unknown. Moreover, there may be insufficient cooperation from partners, particularly in large partnerships, to achieve a significant reduction in partnership liability through the filing of amended returns. Partnerships desiring to take advantage of these procedures should, therefore, consider adding provisions to their partnership agreements requiring partner input, when needed, in order to enable the partnership to do so.
2. Partnership Election to Shift Liability to Partners
A partnership that elects to issue adjusted Schedules K-1 to all of the partners that were partners of the partnership during the Reviewed Year (the Elective K-1 Approach) will avoid imposition of a partnership-level tax. The partnership must make this election and issue the adjusted Schedules K-1 within 45 days of the receipt of a notice of final partnership adjustment from the IRS. When a partnership makes this election and timely issues the adjusted Schedules K-1, the partners of the partnership during the Reviewed Year automatically assume the tax liability for any partnership-level audit adjustments. Such partners must take the adjustments into account on their individual tax returns for the year in which they receive the adjusted Schedules K-1. Under this election, interest and penalties are determined at the partner level, but interest on the underpayment is calculated at the federal short-term rate plus five percent (two percentage points higher than the rate generally applicable to underpayments). Thus, the New Audit Rules exact a price from the partners in the form of a higher interest rate on any understatement of tax where the partnership elects to shift the tax liability to its partners.
The New Audit Rules replace the concept of a TMP with a "partnership representative." The partnership must designate a person with a "substantial presence in the United States" as the partnership representative. In the absence of the partnership making such designation, the IRS has the authority to appoint any person as the partnership representative. Unlike a TMP, the partnership representative does not need to be a partner. The partnership representative has the sole authority to act on behalf of the partnership in an audit proceeding, and to bind the partnership and the partners to any resolution thereof. The considerable power vested in the partnership representative, broader than that accorded a TMP under currently effective law, implicitly denies the partners the ability independently to participate in the audit process and to settle with the IRS on an individual basis.
Partnership-Level Statute of Limitations
Under the New Audit Rules, the statute of limitations within which the IRS must make a tax adjustment with respect to a partnership's taxable year does not begin to run until the partnership files its return for such year. Although this is already the case under currently effective law for those entities that are covered by TEFRA or that are ELPs, it represents a change with respect to small partnerships, which are exempt from the TEFRA regime, and, as such, are currently subject to statutes of limitations determined by reference to each individual partner.
The New Audit Rules raise a number of critical issues for partnerships and their partners.
Many incoming partners will be concerned that they may indirectly bear a share of historic tax liabilities in the event that the partnership does not avail itself of the Elective K-1 Approach. This may lead partnerships (that cannot meet the requirements of the Election-Out) to avoid the issue of liability at the partnership level, and related shifts in tax liability away from the appropriate partners (i.e., those who were partners in the Reviewed Year), by adopting the Elective K-1 Approach, notwithstanding the associated potential administrative complexities and higher underpayment interest costs.
Where there is no commitment in a partnership agreement to pursue the Elective K-1 Approach, incoming partners will be well advised to protect themselves from potential historic tax liabilities by negotiating with the partnership for appropriate representations, warranties, and indemnities in a side letter, or, where applicable, sales agreements. All partnerships will need to consider appropriate revisions to existing partnership agreements—preferably, long in advance of the Effective Date—to make clear which procedures under the New Audit Rules will be followed.
REMICs, as noted above, under currently effective law are exempt from the TEFRA rules if they have a single residual interest holder. It is not yet clear whether this rule will be extended to exempt such REMICs from the New Audit Rules. If not, such REMICs, as well as those with more than a single (but under 100) residual interest holder(s), all of which are Qualifying Partners, presumably will choose the Election-Out so as to prevent a REMIC-level tax that could adversely impact expected yield to their investors.
As noted above, many important details of the New Audit Rules remain unclear and are expected to be clarified in forthcoming regulations. We will, of course, keep clients abreast of any material developments.