New Partnership Audit Rules
A new law which significantly changes the way partnerships will be audited by the IRS has gone into effect for taxable years beginning after December 31, 2017. This new law impacts every partnership and limited liability company (“LLC”) taxed as a partnership.
TAX EQUITY AND FISCAL RESPONSIBILITY ACT (“TEFRA”)
Under the previous law (Tax Equity and Fiscal Responsibility Act or “TEFRA”), partnership audits were conducted at the partnership level and adjustments to partnership items were made at the partnership level. Once the adjustments were made, the IRS made corresponding adjustments to each partner’s return with any additional taxes, penalties and interest collected from the partners. There were limited exceptions to the TEFRA rules for small partnerships with 10 or fewer partners.
The new law repeals the TEFRA audit rules and subjects all partnerships, including those with 10 or fewer partners, to a centralized partnership audit regime. The centralized partnership audit regime provides for a centralized audit proceeding, assessment and collection of tax, penalties and interest from the partnership. As a result, the burden of such taxes, penalties and interest fall on persons who are partners in the year the additional taxes, penalties and interest are assessed (“Adjustment Year”), rather than the persons who were partners in the year under audit (“Reviewed Year”). In addition, because tax is imposed at the partnership level at the top marginal rate and tax attributes of partners are not taken into account, the tax liability of the partnership can often exceed the tax liability that would have been imposed on the partners directly.
“ELECT OUT” ELIGIBILITY
Certain partnerships will be eligible to elect out of the centralized partnership audit regime. If a partnership elects out, the assessment and collection of any additional taxes, interest or penalties due would be imposed at the direct partner level. In order to elect out, a partnership must have 100 or fewer partners for the taxable year, and all of the partners must be eligible partners. Eligible partners are individuals, C corporations, foreign entities that would be treated as C-corporations if they were domestic entities, S-corporations and estates of a deceased partner. As a result, a partnership that has another partnership, trust or disregarded entity as a partner is not eligible to elect out of the centralized partnership audit regime even though it may have fewer than 100 partners. This will significantly limit the number of “eligible partnerships” that can make an election out of the centralized partnership audit regime. If an election out is made, partnership audits will be conducted under the pre-TEFRA rules. Under those rules, all audits and assessments will be made at the partner level, rather than in a unified audit proceeding at the partnership level.
These new audit rules replace the Tax Matters Partner (“TMP”) put in place under the TEFRA rules with the Partnership Representative (“PR”). Although the TMP typically represented the partnership during audit proceedings, he was responsible to notify all partners of the proceeding and alert the partners of their right to participate in the audit proceeds. Under the new law, the PR is the only person who may act on behalf of the partnership and the partners do not have any notification or participation rights. The partnership and all partners are bound by any actions or decisions of the PR. Unlike the TMP, the PR does not have to be a partner but is required to have “a substantial presence in the United States”. Proposed regulations provide that a person has a substantial presence in the U.S. if: (1) the person is available to meet in person with the IRS at a reasonable time and place; (2) the person has a street address that is in the U.S. and a telephone number with a U.S. area code; and (3) the person has a U.S. taxpayer identification number.
As discussed above, if there has been a change in the partnership group from the Reviewed Year and the Adjustment Year, it could result in certain partners bearing the burden of additional tax assessments for a year in which they were not a partner or owned a smaller interest in the partnership. Under the new law, the partnership can elect to have an underpayment that was originally assessed against the partnership newly assessed against the review year partners instead. This election, referred to as the Push-Out Election, must be made no later than 45 days after the notice of final partnership adjustment (“FPA”) is issued by the IRS. Typically, the election, which is binding, is required to be made before the outcome of the partnership proceeding is known.
REVIEWING YOUR AGREEMENT
This new law significantly changes the way partnerships will be audited, and we strongly recommend that our clients review and in many cases amend their partnership/LLC agreements to account for these changes. Among the items that should be addressed include the following:
• Naming of the Personal Representative and a spelling out of the PR’s obligations to the other partners in the case of an audit.
• The agreements should carefully address the circumstances in which an Election Out of the centralized audit procedures will be made. Partnerships that want to assure that they will be able to make an Election Out may wish to consider revising the transfer provisions of their partnership agreements to prohibit transfers to any person who is not an eligible partner.
• The partnership agreement should address whether partners from the Reviewed Year will be required to indemnify partners in the Adjustment Year for any additional taxes, interest and penalties of which those partners will bear the burden, or if the Partnership will be required to make a Push-Out Election.
FOR MORE INFORMATION
Depending upon the specifics of your partnership agreement, these changes can be significant and complex. We encourage you to contact us if you would like us to discuss these changes with the attorney who drafted your partnership/LLC agreement, or if you would like us to review your existing or amended agreement with regards to how it applies to these law changes. For such inquiries, or for information about our services, please contact us at firstname.lastname@example.org or (212) 245-5900.