Major Changes in Partnership Audit Procedures Contained in 2015 Budget Act
Contained in the Bipartisan Budget Act of 2015 (the “BBA”), signed by President Obama on November 2, is a rather complex provision that materially changes how partnerships are audited. Generally effective for tax years beginning after December 31, 2017, the so-called “TEFRA” and “Electing Large Partnership” rules under current law are repealed and replaced by a single set of rules for auditing partnerships and their partners at the partnership level. The IRS and Treasury anticipate that the new audit procedures will make it easier to collect deficiencies. Indeed, the Congressional Budget Office scored this provision as a significant revenue raiser over the next 10 years.
Certain partnerships will be able to opt out of the new rules, in which case the partnership and partners would be audited under the general rules applicable to individual taxpayers. Specifically, partnerships with 100 or fewer partners will be able to elect out of this regime for a taxable year, provided that each partner is an individual, a C corporation, a foreign entity that would be a C corporation if it were domestic, an S corporation (each shareholder being treated as a partner for purposes of the 100 partner limit and the disclosure requirement, noted below) or the estate of a deceased partner. Such election will be made with a timely filed return for the taxable year and include a disclosure of the name and taxpayer identification number of each partner. The partnership will also be required to notify each partner of such election.
Under the new audit regime, the IRS will examine a partnership’s items of income, gain, loss, deduction, credit and partners’ distributive shares for a particular year of the partnership (the “reviewed year”). Any adjustments will be taken into account by the partnership (NOT the individual partners) in the year the audit or any judicial review is completed (the “adjustment year”); the partnership will be liable for related penalties and interest. The tax deficiency arising from the partnership level adjustment (the “imputed underpayment”) will be calculated using the maximum statutory individual and corporate income tax rates. Partners will not be subject to joint and several liability for any liability determined at the partnership level.
Procedures will be established under which the imputed underpayment amount may be reduced: (i)(a) to the extent partners voluntarily file amended returns for the reviewed year, (b) the returns take into account all adjustments properly allocable to such partners and (c) any tax due by such partners for the reviewed year is paid with the returns; or (ii) if the partnership demonstrates that a portion of the imputed underpayment is allocable to partners that are tax-exempt or are taxed at lower than the maximum corporate or individual (i.e., qualified dividend or capital gain) tax rate used in computing the imputed underpayment amount. In the case of any adjustment which reallocates the distributive share of any item from one partner to another, all partners affected by such adjustment must file amended returns for the imputed underpayment amount to be modified through the filing of amended returns under item “(i)” above.
A partnership will generally have 270 days to submit information to the IRS when requesting a modification of the imputed underpayment amount following the making of a proposed partnership adjustment, unless the period is extended with the consent of the IRS.
Alternative to Imputed Underpayment
As an alternative to taking the adjustment into account at the partnership level, a partnership can elect to issue adjusted information returns – adjusted Form K-1s – to the reviewed-year partners (and the IRS). Those partners would then take their share of any adjustments (as determined in a notice of final partnership adjustment) into account on their individual returns in the adjustment year and would be liable for related penalties and interest, with deficiency interest calculated at an increased rate and running from the reviewed year.
A partnership would be required to elect this alternative to the payment of the imputed underpayment amount not later than 45 days after the notice of final partnership adjustment.
Adjustment Requested by Partnership
The new regime allows a partnership to file a request for an administrative adjustment in the amount of one or more items of income, gain, loss, deduction, or credit of the partnership for any partnership taxable year, with the adjustment taken into account for the partnership taxable year in which the administrative adjustment request is made. The partnership would generally be permitted to take the adjustment into account at the partnership level or issue adjusted information returns (as described above) to each reviewed-year partner; in the case of an adjustment that would not result in an imputed underpayment, a partnership would issue adjusted information returns to reviewed-year partners.
A partnership may not file such a request more than 3 years after the later of (i) the date on which the partnership return for such year is filed or (ii) the last day for filing the partnership return for such year (determined without regard to extensions). In no event could a partnership file a request after a notice of an administrative proceeding with respect to the taxable year is mailed to the partnership and “partnership representative” (see below).
The provision also contains the following –
Consistent Treatment. A partner, on the partner’s return, is required to treat each item of income, gain, loss, deduction or credit attributable to a partnership in a manner consistent with the partnership return, unless the IRS is notified of the inconsistent position. If a partner fails to notify the IRS, the IRS may assess and collect any resulting underpayment as if the underpayment were on account of a mathematical or clerical error on the partner’s return. A determination as to an inconsistent position in a proceeding to which the partnership is not a party is not binding on the partnership.
If a partnership is a partner in another partnership, any adjustment on account of such partner’s failure to file consistently with respect to its interest in the other partnership will be treated as a mathematical or clerical error, with no request for abatement permitted.
Designation of Partnership Representative. Each partnership is required to designate a partner (or other person, even a non-partner) with a substantial presence in the U.S. as the partnership representative who will have the sole authority to act on behalf of the partnership. In the absence of such designation, the IRS may select any person as the partnership representative. A partnership and all partners are bound by determinations made at the partnership level. Apart from the partnership representative, the IRS is not required to provide notice to partners at the beginning of an administrative proceeding or adjustment.
Electing Early Effective Date. A partnership will be permitted to elect to have the new audit regime apply (other than the 100 or fewer partner “election out” of the new rules) to any return of a partnership filed for partnership taxable years beginning after the date of enactment (i.e., November 2, 2015) and before January 1, 2018.
Treatment When Partnership Ceases to Exist. If a partnership ceases to exist before a partnership adjustment takes effect, the adjustment will be taken into account by the former partners under regulations to be issued.
Judicial Review of Partnership Adjustments. Within 90 days after the date on which a notice of a final partnership adjustment is mailed, the partnership may file for a readjustment for such taxable year with the Tax Court, the federal district court for the district in which the partnership’s principal place of business is located, or the Claims Court. If it wants to file in district court or the Claims Court, the partnership must deposit the amount of the imputed underpayment with the IRS. The court may by order accept a good faith effort to meet the deposit requirement.
With the enactment of the BBA but a few weeks ago, there remain numerous questions with respect to the implementation of this provision. For example, how will it be applied to tiered partnerships? How will “technical terminations” be treated? With potential partnership level tax liability, what about FIN 48 tax accruals? Comprehensive regulations, notices and revenue procedures, and perhaps technical corrections, will be required in advance of the effective date. In any case, partnerships and partners, both existing and new, together with their professional tax advisors, will now need to carefully consider the various alternatives available in dealing with partnership audits and the consequences of adopting one methodology over another.