On June 13, 2017, the Internal Revenue Service ("IRS") issued proposed regulations designed to implement the new partnership audit rules enacted by the Bipartisan Budget Act of 2015 ("BBA"). The proposed regulations, which detail how the IRS will apply the new audit rules, were originally issued in January 2017 but were never officially released due to the regulatory freeze that went into effect under the Trump administration. Partnerships and LLCs need to consider changing their agreements to ensure compliance with the new rules.
New Audit Rules Scheduled to Take Effect in 2018
The new audit rules will apply to LLCs and other entities taxed as partnerships ("partnerships") for tax years beginning in 2018, unless the partnership elects to apply them sooner. The revised rules are a response to the increased use and complexity of partnership structures and the impediments of current law on the IRS's ability to examine and collect taxes from partnerships. The new rules are intended to eliminate these impediments and increase IRS enforcement of tax rules against partnerships.
Significant Powers Vested in the Partnership Representative
One of the dramatic changes made by the new audit rules is the replacement of the "tax matters partner" framework of the current TEFRA rules with a "partnership representative" who will have significantly greater powers than a tax matters partner under the current rules.
Under the new audit rules, the partnership representative is a person designated by the partnership. Once designated, the partnership representative has sole authority to act on behalf of the partnership in examinations by the IRS. Moreover, the decisions made by the partnership representative will be binding on the partnership and all partners, and neither the partnership nor the partners will be entitled to receive notice of or to otherwise participate in the examination. The partnership representative's power to bind all partners, and the elimination of the partners' rights to receive notice of and to participate in the examination are significant changes from current law.
Under the proposed regulations, the partnership must designate the partnership representative on the partnership's tax return each year, and the designation for one year is not effective for any other tax year. If the partnership fails to designate a partnership representative, the IRS is authorized to appoint a partnership representative who will have the same powers and authority as a partnership representative appointed by the partnership.
Unlike a tax matters partner, a partnership representative need not be a partner of the partnership but must have substantial presence in the U.S. A partnership representative may be an individual or an entity, but if the partnership representative is an entity, the partnership must identify and appoint an individual to act on the entity's behalf.
Another significant change from current law is that a partnership's designation of a partnership representative may not be changed, including by revocation by the partnership or resignation by the partnership representative, until the IRS issues a notice of administrative proceeding to the partnership or the partnership files an administrative adjustment request for a purpose other than changing the partnership representative. The inability to revoke a designation of a partnership representative under the new rules could create a situation where notice of an IRS examination is sent to a person who is no longer associated with the partnership.
Among other things, partners and partnerships will need to carefully consider designations of partnership representatives in light of the new audit rules. In addition, consideration will need to be given to adding contractual protections that generally do not exist under current partnership and LLC agreements, such as rights to notice, review and comment rights, indemnification provisions and rights to revoke and replace the partnership representative.
Tax Deficiencies Imposed on the Partnership
Another key area of change under the new audit rules is that the partnership itself will be liable for any underpayment of tax resulting from an audit, unless the partnership representative elects to "push out" the adjustment to certain partners. Compared with the current TEFRA rules, under which the IRS must seek payment from the partners, this change shifts the burden of collecting those payments to the partnership.
To determine whether there is an underpayment, the proposed regulations divide partnership items into three types of "groupings." These include the reallocation grouping, for adjustments reallocating items among the partners; the credit grouping, for adjustments to the partnership's credits; and the residual grouping, for all remaining adjustments. The residual grouping might also have subgroupings, such as for ordinary and capital income adjustments.
The determination of any imputed underpayment is made based on the three groupings. The sum of all net positive adjustments in the residual grouping is added to the sum of the net positive adjustments in the reallocation grouping. That total is then multiplied by the highest rate of federal income tax in effect for the audited year. Finally, that product is increased or decreased by any adjustment made in the credit grouping. If the result is a net positive adjustment, then that adjustment is the imputed underpayment.
The partnership representative may request modifications to the determination of an imputed underpayment. To make this request, the partnership representative must provide substantiating documentation along with a detailed description of the structure, allocations, and ownership of the partnership. The IRS will consider various types of modifications, including modification of the taxable rate used to calculate the imputed underpayment, or reductions for adjustments allocable to a tax-exempt partner.
If there is an imputed underpayment, and the partnership makes a valid push-out election, then the liability for the underpayment falls on the parties who were partners in the year being audited rather than on the partnership itself and its current partners. This result creates the potential for controversy between current and former partners. New investors in a partnership may expect that they would be shielded from liability for prior tax years, whereas exiting partners may expect their liability to end when their interest in the partnership does.
In addition to the complex decision of whether or not to make a push-out election, there is uncertainty in how the election applies when a partner is a pass-through entity. The proposed regulations reserve on that issue. The IRS has solicited comments and is giving consideration to approaches for pushing partnership adjustments out beyond pass-through partners, but taxpayers will have to wait for future IRS guidance.
Limited Ability to Elect Out of the New Audit Rules
Only certain partnerships are permitted to elect out of the new audit rules. In order to elect out, the partnership must have 100 or fewer partners, all of whom must be "eligible partners." Eligible partners are individuals, estates of deceased partners, S corporations, C corporations, or foreign corporations. For example, a partnership that has another partnership or a trust among its partners cannot elect out of the new audit rules.
Under the proposed regulations, the election to opt out of the new audit rules is made on a timely-filed partnership return. The election must list the names, taxpayer identification numbers, and tax classifications of each partner. If there is an S corporation partner, the election must list the names, taxpayer identification numbers, and tax classifications of each S corporation shareholder. The electing partnership must notify each of its partners of the election within 30 days of making it.
Although election out of the new audit rules may seem attractive, some partnerships may not want to elect out, even if they are able to do so. The IRS has indicated that partnerships electing out will be targeted for audits, including audits to determine whether those partnerships are being used to avoid the new audit rules. If an electing partnership is audited, the audit process could impose a substantial burden on the partners, who would face audits individually instead of having a single centralized examination. A partnership should take these risks into consideration before electing out of the new rules.
The new partnership audit rules are effective for tax years beginning in 2018, and the IRS has already stated that the effective date will not be delayed. LLCs and other entities taxed as partnerships should take steps to prepare for the complex new rules before they become effective. Existing operating agreements and partnership agreements should be reviewed and revised as necessary. Purchasers of partnership interests should also pay close attention to the increased audit risk as part of their diligence, and obtain appropriate indemnities from sellers for prior tax years.
Please contact Mark Salsbury or Elizabeth Beerman with any questions regarding these important developments.