As partners and members
of U.S. partnerships and limited liability companies (or their CPAs) gleefully came
back to work after ringing in the new year, many started a familiar process:
preparation of their partnership’s tax return. This year, however, most have discovered
a few changes to their partnership’s Form 1065 that will prompt some new questions
like: “Can our partnership elect out of the centralized partnership audit
regime under section 6221(b)?,” which will be quickly followed by “Wait, what
is the centralized audit regime?” and “What is a partnership representative?”
and “Do we have a partnership representative?”
While these questions seem
innocuous, they grow out of the largest change to the taxation of partnerships
in over 30 years. In late 2015 Congress passed the Bipartisan Budget Act of
2015 (“BBA”). For all tax years beginning after December 31, 2017 (or starting
with all 2018 tax years), the BBA, and the regulations thereunder, does away
with the TEFRA audit regime that has been in effect since 1982.
Make no mistake, these
new partnership audit rules are for the benefit and convenience of the IRS. And
while the new centralized audit system largely accomplishes this goal of making
partnership audits much easier for the IRS, it can create significant burdens
for the partners subject to the new system if they fail to properly address key
issues.
Under the BBA the IRS is
generally allowed to adjust most partnership-related items for the tax years
subject to audit (the “Reviewed Years”) at the partnership level. After making
such adjustments, the IRS then calculates any potential underpayment by
multiplying the net positive audit adjustments for partnership items by the
highest marginal federal income tax rate in effect for the relevant Reviewed
Year. Importantly, unless the partnership takes affirmative action through its
newly-minted partnership representative, the default BBA rules grant the IRS
authority to collect this underpayment directly from the partnership in the
year of the adjustment (“Adjustment Year”).
Put differently, the BBA’s
default rules will result in the partners in the Adjustment Year bearing the
economic burden for the audit, even if they were not partners in one or more of
the partnership’s Reviewed Years that gave rise to the adjustments. And, because
the partnership must pay the tax, not the individual partners, the partners cannot
use beneficial tax attributes, such as a lower marginal tax rate or suspended
losses, to reduce or offset the tax liability.
Have I mentioned that
these changes are solely for the benefit and convenience of the IRS?
Mercifully, the BBA gives
partners 3 options to address or minimize the impact of the default rules:
-
Elect
Out.
In certain limited scenarios, the partnership representative may elect, on the
partnership’s timely-filed tax return, to not be subject to the new centralized
audit rules of the BBA. If a partnership elects out of the BBA, any partnership
audit for that tax year will follow the pre-TEFRA rules. As many practitioners have noted, if the
partnership qualifies to elect out of the BBA’s regime, there is no reason to
forgo this election. To be eligible to elect out of the BBA, the partnership
must have no more than 100 K-1s (including all indirect owners through parent entities)
and the partners must all be individuals, C or S corporations, estates, or
certain foreign corporations. Having other partnerships, trusts, and even
disregarded entities (such as grantor trusts and single-member LLCs) as
partners will prevent the partnership from being able to elect out of the
regime.
-
Push-out. If
the partnership cannot elect out of the new BBA regime, the rules permit the
partnership to avoid paying the entity-level tax by having the partnership representative
elect to “push-out” the adjustments to the partnership’s partners in the Reviewed
Years. This option ensures the economic burden of the adjustments is borne by
the partners in the years giving rise to the adjustments. To the extent the
partnership is part of a multi-tier structure, the BBA rules also permit the
push-out election to be made at each level (or requires an entity that fails to
make the election to pay the entity level tax). It is important to note that
the push-out election presents a number of administrative costs for the
partnership that the partnership representative must weigh in deciding if the election
makes sense. The partnership representative must make the push-out election within
45 days of the mailing of the notice of final audit adjustments.
-
Amended
Tax Returns/ Pull-In Procedure. If a partnership fails
(or is unable) to elect out of the BBA’s rules and does not make a push-out
election, it will pay the imputed underpayment, unless one or more of the partners
from the Reviewed Years amends its tax returns for the Review Years to reflect its
share of the proposed adjustments. The IRS will reduce the partnership’s
liability for the underpayment by any amount of the adjustment that a partner
in the Reviewed Years accounts for on an amended tax return. Recognizing that
the amendment process may present significant administrative burdens, including
a potential restart of the statute of limitations for the amending partner, a Technical
Corrections Bill created a simplified “pull-in” process. Under the pull-in
process, the partnership’s liability for the underpayment is reduced by the
amount paid by any partner from the Reviewed Years if that partner (1) substantiates
the amount of tax that would have been owed if the partner had amended its
returns for the Reviewed Years, (2) pays that amount, and (3) makes adjustments
to its tax attributes. This process ensures the partners from the Review Years
bear the burden of the adjustments without a higher interest rate or a new
statute of limitations.
Considering the far-reaching
effect of the new BBA rules, it is also important for partners to consider who
will act as the liaison between the partnership and the IRS. The BBA replaced
the old tax matters partner with a new position––the partnership representative––who
wields sole authority to act on behalf of the partnership in all matters
relating to the examination of the partnership’s tax return, including
administrative appeals, litigation, settlements, statute of limitations extensions,
elections under the BBA, and payment of the tax liability. State law (such LLC
or partnership statutes or state contract law) cannot alter or limit the duties
of the partnership representative.
The designation of the partnership
representative must be made annually and will remain in effect for that partnership
year unless it is formally revoked with the IRS, even if the partnership
changes its representative in later years. The partnership representative is
not required to be a partner of the partnership, and, if the partnership fails
to make an effective designation, the IRS may unilaterally designate the representative
upon commencement of an examination.
Due to this monumental shift
in the partnership audit regime caused by the BBA, owners of partnership or LLC
interests should check in with their advisers to ensure the BBA’s new structure
is addressed in their partnership agreement as they (or their CPAs) begin filling
out the new Form 1065. At a minimum, partners should ensure they have addressed
the process for selecting, removing, and binding the partnership representative.
Further, partners should take time now to agree on how potential audits will be
managed if the election out is not possible and contractually bind all current
(and future) partners to such plan. Finally, to the extent possible, the partnership
representative should make sure the partnership elects out of the BBA’s regime.
While it may take years to see how audits ultimately play out under the BBA,
taking these prophylactic steps now before any potential audit will minimize
the impact of the BBA’s new audit regime on existing partnerships.
