In November 2015, Congress enacted as part of the Bipartisan Budget Act of 2015 (the “BBA”) partnership audit rules designed to make it easier for the IRS to examine partnerships and collect any resulting underpayments through one centralized proceeding. With limited exceptions, partnerships—not their partners or former partners—will now be responsible for tax on imputed underpayments at the highest applicable rate in effect for the reviewed year, currently 37%. To mitigate the potential economic impact of the new audit regime, new and existing operating agreements should include an entirely new section that replaces the old “tax matters partner” designation. The following is a high-level summary of the new rules and is not a substitute for specific tax advice.
The BBA applies to taxable years beginning January 1, 2018
The new rules will be effective for partnership taxable years beginning after December 31, 2017, but partnerships can elect to apply them early. For calendar-year multi-member LLCs and other entities taxable as partnerships, the new rules will become effective on January 1, 2018.
Audit, assessment, and collection of federal income tax deficiencies are at the partnership level
Under the new Internal Revenue Code (“IRC”) Section 6221, audits of partnerships that do not qualify as “small partnerships” (discussed below) will be at the partnership level. Put differently, under the BBA, these partnerships will be treated as if they were C corporations. Except for the “push out” exception discussed below, imputed underpayments of federal income taxes will be assessed and collected at the partnership level.
Partnerships subject to the BBA may “push out” audit liability
Under new IRC Section 6226(a), a partnership may “push out” any audit adjustment to persons who were partners in the reviewed year. To do so, the partnership representative must send a notice within 45 days of the final IRS adjustment notice detailing each partner’s share as determined in the IRS adjustment notice. These partners may pay their share of the tax liability at their marginal rate and not at the highest applicable rate in effect during the reviewed year. If the partnership properly follows the push out procedure, the partnership is not responsible for payment of the adjustment. A push-out election may come with some cost to the reviewed-year partners. The underpayment interest rate is increased by two percentage points. Dependable guidance has not yet been provided by the IRS with respect to required amendment of a partner’s previously filed tax return as a consequence of a “push out” and the potential ripple effect on tax returns for subsequent years.
Absent special circumstances, partnerships should require the partnership representative to push out an adjustment. In some cases, the partnership may wish to consider granting the partnership representative discretion to elect the default rule (i.e., pay tax at the partnership level and not “push out” the tax) for de minimis amounts.
Partners in the adjustment year may bear the burden of reviewed year deficiencies
Unless the partnership does a “push out” under new IRC Section 6226(a) or is excepted from the BBA as a small partnership, current partners (the partners in the “adjustment year”) will shoulder the economic burden of a partnership audit even though the imputed underpayment will always be for one or more prior years (the “reviewed years”). This means that current partners could end up on the hook for tax liability attributable to their former partners.
Partnerships should consider requiring reviewed year partners indemnify the partnership and current partners for imputed underpayments made in the adjustment year. Purchasers of partnership interests should seek information about potential tax obligations for prior years, and understand the risk of being held responsible for such obligations.
The elect-out exception for small partnerships exception is narrow
A partnership may elect out of the BBA procedures if it has no more than 100 partners comprising only one or more of the following five types of partners: individuals; C corporations; foreign entities that would be C corporations if they were U.S. entities; S corporations; and the estates of deceased partners. Partnerships qualifying as BBA small partnerships must file an election annually with their federal tax return. If they do not do so, they are subject to the new BBA audit procedures.
This narrow definition of small partnerships means several types of partners will disqualify a partnership from electing out, including trusts, LLCs, and partnerships. Partnerships should consider amending their operating agreements to require electing out, if possible.
The partnership representative has sole authority to bind the partnership
Instead of a “tax matters partner,” new IRC Section 6223 requires partnerships to appoint a partnership representative to handle BBA audits, and only the partnership representative may represent partnerships in these audits. Partnership representatives do not need to be partners (or members of the LLC). If a partnership does not appoint a partnership representative, the IRS will appoint one. A partnership representative may be an individual or an entity.
Both at the audit level and any following administrative proceedings, partnership audits bind not only partnerships but also their partners. See IRC Section 6223(b). Only the partnership representative may participate in a partnership audit. Under the BBA, the partnership representative is not required to give notice of a partnership audit to the partners.
Partnership or LLC agreements should specify the level of notice to the partners in BBA partnership audits (e.g., commencement of the audit, updates on progress, adjustments, appeal options, etc.) and consider limiting the partnership representative’s authority (e.g., conditioning the partnership representative’s settlement authority on partner/member consent).
Tax rate applied to imputed underpayments is the highest applicable rate
As noted above, the rate of federal income tax on partnership imputed underpayments is the highest rate in effect during the reviewed year under IRC Sections 1 or 11. For 2018, this rate is currently 37%.
The IRS has not yet finalized a complete set of implementing regulations
The IRS released a comprehensive set of proposed rules on June 14, 2017, of which only a small subset have been finalized as of the date of this post. The finalized regulations address only the “elect-out” provisions of the BBA.
New and existing operating agreements will require an entirely new section in their operating agreements to address and mitigate the harshest effects of this new audit regime. If you have any questions, please contact Nate Somers or one of the other attorneys in MPBA’s business transactions group.