The Bipartisan Budget Act of 2015 (P.L. 114-74) includes a complete overhaul of the procedures that apply to Internal Revenue Service (IRS) audits of partnerships, including limited liability companies (LLCs) taxed as partnerships and their partners. The Act also repeals the Tax Equity and Fiscal Responsibility Act (TEFRA) audit rules that have been in place since 1982 and the reporting and audit procedures for electing large partnerships in effect since 1998. Unfortunately, while there is substantial uncertainty about how the new procedures will be implemented, it is clear that the Act will have a significant impact on entities operating in partnership or LLC form. These entities are therefore advised to anticipate issues and address them proactively for transactions currently being negotiated. In addition, amendments to existing transaction documents and governing instruments will be necessary in many instances.
The Act, signed into law on Nov. 2, 2015, makes the following major changes to the partnership audit process:
- The "tax matters partner" (TMP) is replaced with the "partnership representative."
- Liability is imposed at the partnership level rather than at the partner level for partnership audit adjustments.
- Liability is imposed in the year of an adjustment rather than the tax year to which an adjustment relates.
The Act gives the IRS broad authority to issue regulations to implement the new law. Thus, many questions raised by the Act will have no clear answers until these regulations are issued. This alert addresses some of the initial questions raised by the Act and makes recommendations for amending existing partnership agreements and LLC operating agreements.
New Partnership Audit Rules
Partner Representative Replaces TMP. The TMP has been eliminated and replaced with the new concept of a partnership representative. Unlike the TMP under current law, the partnership representative need not be a partner, but must have a substantial presence in the United States. The partnership representative will have sole authority to act on behalf of the partnership in connection with an audit. If the partnership fails to name a representative, the IRS may designate one. Under prior law, any partner generally had the right to participate in a partnership audit; under the new regime, it appears that only the single partnership representative will be permitted to participate. The partnership and all of its partners will be bound by actions taken by the partnership representative in the audit process. As a result, partners will want to consider carefully who will retain the right to designate the partnership representative.
Partnership-Level Taxation. Under the Act, the partnership will be liable for any additional tax imposed as a result of a partnership audit adjustment. The entity-level taxation of partnerships represents a significant divergence from established tax principles. The partnership-level tax on the audit adjustment (termed the "imputed underpayment amount" under the Act) is determined without the benefit of partner-level tax attributes that otherwise could reduce the tax due on any adjustments. For example, it appears that the net operating losses of a partner cannot be used to offset any additional partnership income. Likewise, income that would be allocated under a partnership or LLC operating agreement to a tax-exempt partner may now be subject to taxation at the partnership-level. The adjustment generally is calculated assuming the highest rate of tax in effect for the reviewed year. Additionally, no deduction is allowed for the tax, interest or penalties paid by the partnership. The IRS is directed by the Act to promulgate regulations to establish procedures under which the imputed underpayment amount may be adjusted to reflect the realities of the partners' tax positions, such as excluding the amount allocable to a tax-exempt partner or using a reduced tax rate for capital gains or qualified dividends allocable to an individual partner.
Adjustment Year. Under the new rules, the partnership takes into account audit adjustments in the taxable year in which the audit (or any judicial review) is completed—referred to as the "adjustment year." All partnership and partner adjustments related to the audit are made in the adjustment year (with an enhanced interest rate applied). This represents a significant departure from the treatment of adjustments under the current TEFRA regime. As a result, the new rules could shift the cost of an assessment of tax due to persons that are partners in the adjustment year, rather than a simple flow-through of adjustments to the partners who benefitted from the underpayment in earlier years. For partners seeking to exit a partnership, this may provide added comfort because subsequent audits would not impact the investor. For parties joining an existing partnership, this may require consideration of additional indemnification provisions for new partners.
Opt-Out for Small Partnerships. The new rules include an "opt-out" election for partnerships with 100 or fewer partners (small partnerships) to elect not to apply the new partnership audit rules. In determining whether a partnership meets the 100 or fewer shareholders requirement, each shareholder of an S corporation that is a partner in the partnership is treated as a separate partner. More importantly, an opt-out election is not available to partnerships if another partnership is a partner (tiered partnerships), unless the IRS issues future guidance extending the election under such circumstances (a possibility that is expressly contemplated in the Act). It appears at least reasonably likely that future IRS regulations will allow a small partnership that has a partner that is itself a small partnership to opt out. However, as the law stands now, in a typical tiered partnership fund structure, the election to opt out is not available for lower-tier partnerships. Where a decision to opt out is available, the partnership must make an affirmative election annually on a timely filed return and include appropriate information to help the IRS identify the partners, including each partner's name and Taxpayer Identification Number. Thus, currently negotiated transaction documents should include provisions that require or allow the annual election to be made if it is available. With the repeal of the TEFRA audit rules starting in 2018, if a partnership opts-out of the new regime, the partners will be audited under the pre-TEFRA rules. In other words, there would be no unified partnership proceedings and all adjustments and litigation would occur at the partner level.
Deciding Whether to Opt-Out. While the decision on whether or not a partnership should opt-out will depend heavily on future IRS regulations, there are some potential benefits to the new regime. For example, under the new rules, if the IRS makes an audit adjustment, the partnership itself generally will be liable for the tax due. The Act is silent as to whether the partners are liable for an audit adjustment if the partnership still exists, but is unable to meet its obligation (due to the partnership's bankruptcy or insolvency). A legislative summary of the Act appears to indicate that partners would not be liable if the partnership is unable to make the payment. While this should be carefully monitored, it is difficult to imagine that this result was intended or will survive IRS clarifying regulations. Similarly, the new rules appear to provide that the statute of limitations for assessment by the IRS generally is three years from the later of the following: (1) the due date of the return without regard to extensions, (2) the filing of the partnership's tax return and (3) the filing of an administrative adjustment request. Under prior law, the IRS applied the statute of limitations based on the last to expire of the partnership's or each partner's statute of limitations. For many partners, the new regime would be a welcome change in this regard, as tolling agreements result in a considerably longer statute of limitations period.
Electing Out of Partnership-Level Taxation. The Act provides for two ways in which the partnership can elect to push down the audit adjustments to prior year partners. These exceptions differ from the opt-out available for small partnerships discussed above. First, the partnership may elect to push down the items of adjustment to all prior year partners. The election must be made within 45 days of the final notice of adjustment, and the partnership must furnish to each prior year partner and to the IRS a statement of each partner's distributive share of each item of adjustment. The prior year partners are then responsible for paying tax on their share of the adjustment, plus interest at a slightly enhanced rate. The ability to compel or forbid this election is likely to be a focus for many partners, although the importance of this issue will be driven by the regulations to be promulgated. Second, if a partnership cannot meet the requirements or does not wish to elect out under the rule mentioned above, the partnership may reduce its liability for an adjustment if it complies with certain adjusted information return procedures, which the Act directs the U.S. Treasury Department to establish through regulations. More specifically, if within 270 days of the partnership's receipt of the notice of proposed adjustment, (1) the partnership issues new Form K-1s to its partners, (2) the partners file amended tax returns to take into account the adjusted Form K-1s and (3) the partners pay the tax liability, the partnership may compute the amount of tax it owes without regard to the income taken into account by the partners. If an adjustment occurs as a result of a reallocation of the partners' distributive share of income, all partners affected by the adjustment must file amended returns in order for the partnership to reduce its liability. The partnership still will be liable for the tax on any adjustment that is not pushed down to the prior year partners.
Effective Date. The new rules generally apply to IRS audits of partnership returns for 2018 and subsequent taxable years. However, partnerships may affirmatively elect to have the new regime apply for the 2015 through 2017 taxable years. For existing partnerships, it is advisable to review whether the current TMP is required to seek consent prior to making such an election. It also is noteworthy that the TMP provisions in the Code were repealed by the Act. Existing partnership or LLC operating agreements will need to be amended to reflect the elimination of the TMP concept. Additional restrictions on general partner or manager authority related to the new regime also may be addressed via amendments to existing partnership and LLC operating agreements. For deals closing in the near future, we advise that these issues be addressed in some reasonable fashion, taking into consideration the absence of IRS regulations.
Issues that Partnerships Need to Address
There are a number of key issues to monitor, consider and discuss with your partners/members. In addition to those noted above, consider the following key issues:
1. Existing partnership and LLC operating agreements should be reviewed, and amendments will need to be drafted to address aspects of the new rules, including:
- designating the partnership representative in place of the TMP
- determining the partner(s) that will control the decision to opt out of the new regime
- preventing assignments of partner interests to persons that would preclude the ability to opt-out
- addressing the payment of entity-level tax
- committing to making certain elections in the event of an audit adjustment
- addressing circumstances where partners agree to "adjusted information returns" in lieu of entity-level tax
2. Negotiations will be necessary to determine the appropriate partnership representative and the contractual limitations on the authority of such representative.
3. In secondary market transactions, parties acquiring partnership interests will need to consider their potential share of the partnership's liability with respect to prior tax years if the partnership has not elected out of the new regime. Parties may want to include certain protection provisions to address this issue in the entity's governing documents or in agreements governing the transfer.
4. Many technical tax issues arise from subjecting partnerships to tax that will need to be considered. For example, provisions governing the allocation of the tax paid by the partnership will be necessary where the tax profiles of the partners differ. Many partnership agreements and LLC operating agreements allocate items based on the partners' percentage interest in the partnership; however, some partners, such as tax-exempt entities, may not find this allocation scheme appropriate. In such a situation, the partners would likely prefer to allocate the tax expense based on the relative amounts for which the partners would be liable if assessment was made at the partner level rather than at the partnership level. However, this will significantly increase administrative and bookkeeping costs, and the partners will have to balance the added burden of this allocation scheme against the benefits from the more economically accurate allocation.