Background
On November 2, 2015, President Obama signed into law the Bipartisan Budget Act of 2015 (the “BBA”), which contains significant changes to the partnership audit procedures used by the Internal Revenue Service. The BBA was enacted due to the increasing difficulty the IRS was experiencing in auditing partnerships due to various cumbersome rules and procedures, especially as they relate to multi-tiered partnerships. The full text of the BBA is available at https://www.congress.gov/114/plaws/publ74/PLAW-114publ74.pdf. References in this memo to “partnerships” and “partners” include limited liability companies that are taxed as partnerships and their members, respectively.
Current Rules
Under current law, partnerships with ten or more partners are generally audited under the unified audit rules created by the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”). The TEFRA audit rules provided for the IRS to conduct the audit process at the partnership level (rather than multiple audits at the partner level), interacting with a “tax matters partner.” If the audit process resulted in an adjustment to a prior year’s return, the resulting deficiencies would flow through to, and be payable by, the individual partners. However, the IRS does not have the resources or capabilities to audit large partnerships (many of which have thousands of partners), particularly given that what would be a relative large adjustment at the partnership level often became a very small amount when spread among numerous partners. Unlike with corporations, under current law the IRS cannot simply assess taxes against partnerships — it has to find each of the individual partners, pull their tax returns, compute the tax adjustment, and send every one of them a notice. The cost of collecting minor adjustments from many partners frequently outweighs the benefits of collecting these sums.
As a result, during the last several years the IRS has audited less than 1% of “large” partnerships (as compared to more than 27% of “large” corporations), with very little tax being collected from these audits. The BBA significant revises the partnership audit rules by enabling the IRS to collect tax adjustments directly from the partnership in question, shifting the burden of passing adjustments to partners from the IRS to the partnership. The IRS will deal with a single “partnership representative”, and individual partners will have no right to notice of, or to participate in, partnership audits. Projected revenue to be collected over ten years from these new rules exceeds $10 billion.
New Rules
The BBA becomes effective for tax returns filed for tax years beginning after December 31, 2017 (although an election can be made to opt into the BBA prior to that date). While all partnership adjustments to income, gain, loss, deductions, and credits continue to be calculated at the partnership level, all tax liability resulting from such adjustments is assessed and may be collected directly from the partnership.
As noted above, under the BBA, audits (and any litigation arising out of an audit) are conducted at the partnership level — all partners are bound by a final resolution in the partnership proceeding; partners do not have the right to participate in the proceeding; the IRS is not required to notify the partners of a proceeding; penalties are determined at the partnership level (there are no partner level defenses to penalties); and the statute of limitations is determined solely at the partnership level.
One of the default rules of the BBA is that partnerships are assessed tax liability on the “imputed underpayment amount.” A partnership is generally assessed tax at the highest individual or corporate tax rate (i.e. 39.6%), unless it can establish that the tax should be lower (for example, a partner may be a tax-exempt entity or all or a portion of the imputed underpayment is ordinary income and would be allocable to a C corporation, or all or a portion of the imputed underpayment is capital gain or dividend income and is allocable to an individual partner). In addition, the “imputed underpayment amount” is reduced to the extent that partners for the “reviewed year” file amended returns reflecting the amount of the underpayment for the tax year being reviewed and pay the tax due. Such returns must be filed, and such taxes paid, within 270 days of the partnership’s receiving a notice of a proposed partnership adjustment.
Under the default rules, the partnership (rather than the partners) is required to pay the “imputed underpayment amount.” As a result, the burden to pay tax due in respect of prior tax years is borne by the current partners. If the current partners are identical to the partners for the reviewed year, and currently own the partnership in the same proportions as they did throughout the reviewed year, then the default rules will be of no import. However, partnerships, particularly large partnerships, rarely remain owned by the same partners in the same proportions for any significant amount of time. The BBA recognizes this fact, and provides relief via an alternative mechanism for payment of the imputed underpayment by the partners. If the partnership chooses this alternative within 45 days after receiving a notice of final partnership adjustment, the partnership must then provide to each partner who was a partner during the year reviewed and to the IRS a statement reflecting the partner’s share of the adjustment. The partners receiving the statements are required to pay the tax due and are liable for interest and penalties, with no right to an administrative or judicial review (each partner is bound by the partnership-level determination).
Another major change from the TEFRA rules is the transition from the old “tax matters partner” role to a new “partnership representative.” The “tax matters partner” was required to be a partner of the partnership. The “partnership representative” is not required to be a partner, but does have to be a person who has a “substantial” United States presence. The “partnership representative” has significantly more authority under the BBA as compared to TEFRA to bind the partnership and its partners in an audit. The IRS will appoint a “partnership representative” if the partners fail to do so.
Opting Out
The BBA does provide relief to certain small partnerships, which may elect out of the new audit procedures. Small partnerships generally include those that (1) have fewer than 100 partners, (2) partners may only be individuals, estates of deceased partners, C corporations, or S corporations, and (3) comply with certain other rules. If any of the partners is another partnership, a limited liability company, a trust, etc., the opt-out election cannot be made. If the election is made, the IRS will make determinations at the partner level (similar to the TEFRA small partnership rules). This election is required to be made on an annual basis, and must include a disclosure of the name and taxpayer identification number of each partner, including information with respect to each S corporation shareholder treated as a partner. In addition, the partnership must notify each partner of the election.
Next Steps
Although the BBA does not become effective until 2018 (unless an election is made to opt in early), as with most significant changes to the tax law, early planning will be essential to safeguard the interests of those owning or acquiring partnership interests. Among the issues that need to be considered are the following:
• Whether the partnership should elect into the BBA prior to its effective date.
• Whether the partnership agreement should contain a mandatory election out of the BBA if the partnership is eligible to make such election.
• How the partnership should select, remove and replace the “partnership representative.”
• To the extent allowed by the BBA or its implementing regulations, limitations on the “partnership representative’s” authority and provisions requiring the “partnership representative” to give notices to the partners of any audit (and any related developments) and to allow the partners to participate in the audit process.
• Whether the partnership agreement should contain an indemnity or reimbursement provision for taxes paid by the partnership that should otherwise have been paid by a partner.
• The method by which the partnership can elect the alternate mechanism for payment of audit adjustments, which could be, for example, mandatory for adjustments over a certain amount or determined by the partnership representative or by a required vote of the partners.
• Provisions permitting the “partnership representative” to pay taxes from partnership accounts, or to call for capital or loans to pay taxes (and penalties for partners who fail to fund).
• For partnerships that are able to opt out due to their ownership, adding provisions prohibiting transfers that would preclude the partnership from future opt outs, and remedies in the event a partner attempts to make such a transfer.
• Provisions requiring each partner to provide any information required to enable the partnership to opt out if it’s eligible to do so, and limiting the partnership to no more than 100 partners.
• Indemnification provisions in favor of the “partnership representative” and in favor new partners with respect to prior tax periods.
• Escrow and indemnification provisions for partners who are selling their partnership interests.
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Please not that this is only a brief summary of certain provisions of the BBA. Although law, the BBA leaves many questions unanswered and will require significant guidance (or outright amendment) to fill the gaps inherent in the legislation.
Individuals who are, or who own interests in entities that are, partners in a partnership should carefully review the BBA and their existing partnership agreements to determine what revisions may be required to these documents to address the changes being brought about by the BBA. Please contact one of the attorneys in our Corporate and Commercial Transactions Practice Group if you have any questions about this memo or how the BBA’s provisions may affect you, including, for example, how the BBA may impact your existing or future agreements. We would be happy to assist you.