Getting Ready for the New Partnership Audit Regime
The Tax Equity and Fiscal Responsibility Act (“TEFRA”) partnership audit rules and Electing Large Partnership Rules are being replaced by a new audit regime adopted in the Bipartisan Budget Act of 2015 (“BBA”). The BBA dramatically changes the partnership audit rules from a regime that passed through the partnership adjustments to collect tax, penalties, and interest from the partners, to a regime that allows for collection directly from the partnership. Congress is making these changes in response to concerns that the IRS was unable to effectively and efficiently audit partnerships due to cumbersome rules and procedures (and as a result, partnerships weren’t being audited). The intent of the BBA is to streamline partnership audits so that a final decision is binding on the partnership and partners and to reduce the burden of the government.
The new partnership audit rules are generally effective for tax years beginning after December 31, 2017. There is an early adoption provision if a partnership makes an election to apply the new rules to returns filed for tax years beginning after November 2, 2015.
Although partnership audit rules are effective beginning in 2018, with returns filed in 2019, the new audit procedures are unlikely to be put into practice before 2020.
The BBA has done away with the TEFRA “tax matters partner” (“TMP”) designation. Instead, there will be a “partnership representative.” The partnership representative has broad power to make important decisions and elections for the partnership under audit, and so it is important that the partnership agreement address those powers.
OVERVIEW OF THE NEW AUDIT APPROACH
If the IRS adjusts items on a partnership, any tax, penalties, and additions to tax will be determined, assessed, and collected at the partnership level. The partnership pays any imputed underpayment with respect to the reviewed year. The “imputed underpayment” is the net of all partnership adjustments for the reviewed year multiplied by the highest individual or corporate tax rate.
Under these rules, the burden of the tax liability due to IRS adjustments will be borne by persons who are partners in the partnership during the year the adjustment is made, rather than the year the income that resulted in the tax liability was earned. Therefore, persons acquiring an interest in a partnership should be aware of possible understatements by the partnership in earlier years.
There are 3 options to either bypass or modify the partnership imputed underpayment. The first procedure is for a partnership to request a modification to the IRS partnership adjustments. The modification rules will serve to more closely reflect the tax that would have been due by the partners had the partnership and partners correctly reported and paid in the tax. The second option is to elect out of the new audit rules for certain partnerships with 100 or fewer partners that meet the requirements. Alternatively, a partnership can make the so-called “push-out” election. This election allows the partnership to shift the liability for the imputed underpayment to the partners who were partners during the year under audit.
The push-out election can be useful in vehicles, such as hedge funds, where there may be significant changes in the number and identity of partners from year-to-year.
PROPOSED TECHNICAL CORRECTIONS
Technical corrections related to the partnership audit rules were proposed in 2016. The corrections were intended to make fundamental changes and to clarify terms and processes so as to improve enforcement by making the audit of partnerships easier to administer. The Tax Technical Corrections Act of 2016 was not adopted; however, its provisions are likely to be the starting point for any changes in the partnership audit rules that are incorporated in tax legislation in 2017.
Key elements that the technical corrections are attempting to modify are to: expand the scope of statute to “partnership-related items;” provide clarification that entity level tax is computed without netting, where netting is inappropriate in determining the imputed underpayment; add additional requirements in making the push-out election and clarify that push-out applies in tiered arrangements; include a new “pull-in” procedure that allows partners to be pulled into a partnership audit; and provide regulatory authority to prescribe guidance under which the partnership audit rules do not apply and provide for special rules to apply to certain special enforcement matters.
On January 18, 2017, the IRS issued proposed regulations on implementation of the rules for partnerships subject to the new audit regime. However, the proposed regulations were withdrawn pending review by the new administration as a result of President Trump’s executive order initiating a moratorium on all federal rulemaking.
WHAT PARTNERSHIPS AND PARTNERS NEED TO CONSIDER
Given the impact of the new audit rules, many partnership agreements and operating agreements will need to be amended. Now is the time to consider any necessary changes. The following issues should be considered and discussed with a tax advisor:
- Partnership Representative – What procedures should be put into place for selecting a partnership representative? Who should be the partnership representative? What are the representative’s specific duties? Can the operating agreement limit the partnership representative’s authority? Should the partnership representative be obligated to notify all of the partners of the audit? Can limited partners participate in the audit process? Can the operating agreement require cooperation among all the partners to reduce the imputed underpayment calculation? Although the partnership representative clearly binds the partnership, the partners can still remove the partnership representative.
- Partnership Elections – Should the partnership include a provision for early adoption of the rules? Should the operating/partnership agreement contain a mandatory election out? If the partnership opts out, TEFRA rules will not apply either. Instead, the partnership will be subject to pre-TEFRA process of the IRS asserting deficiencies against individual partners either following a partnership exam or as part of an individual exam; does the partnership want that? Will these partnerships that opt-out then become low priority for IRS examinations? Should the partnership include a provision for the “push- out” election? Is the partnership eligible to make certain partnership elections?
- Eligibility to Opt Out – Should the partnership agreement or subscription documents contain provisions that partners cannot transfer interest to impermissible partners or partners that would cause the total K-1s to exceed 100?
- New Partners #8211; New partners should consider any potential tax obligations for prior years. Should a new partner who did not own an interest in the partnership in a reviewed year be liable for tax paid by the partnership? Should the partnership agreement prohibit transfers of partnership interests to persons who would terminate? Should partners request side letters to ensure partnerships make the opt-out election or the push-out election?
- Payment of Tax and Expenses – If the partnership pays tax assessed, how should the partnership collect from former partners that were partners in the year reviewed but are no longer partners in the year the tax is paid? Should the current partners bear the financial burden? Should the partnership agreement contain a provision for partner indemnification of partnership payments? How should the expenses of dealing with the audit be treated? How will tax payments made by the partnership be processed and collected?
- General Partner Issues – Will the partnership tax hit the incentive fee? Should this be worked into the partnership agreement so that there will be no impact to the incentive fee? Should the GP convert to an S corporation structure so the fund can be eligible for the opt-out election?
- Structure – What is the best way for funds to be structured in light of the new partnership audit rules? Will the rules have an impact on whether a master feeder structure or mini-master feeder structure should be used due to likelihood of being audited?
- Provision for Income Taxes – What consideration should be given as to whether a provision for income taxes should be booked on the financial statements due to a possible imputed underpayment of income tax of the partnership? This may be an important issue if the partnerships issue financial statements that conform to U.S. GAAP. Additionally, will the new rules have an impact on tax return positions taken by funds due to increased audit risk and potential partnership level tax liabilities?
- Tax Benefits of the Partnership Level Tax – How does this impact the net investment income tax (“NIIT”) and self-employment tax (“SE”)? The applicable tax rate at the partnership level does not factor in the NIIT or SE tax, so these taxes may be avoided.
- Business Issues – Where is management responsibility placed? Is responsibility placed with new partners or former partners? There are competing interests here. If the push-out election is made, will new partners be motivated to contest proposed changes on behalf of former partners? The new partners may not want to spend time or resources on contesting the changes. Will the former partners be represented in the audit?
- Fund partnership and operating agreements will need to be updated. Instead of a TMP, a partnership representative will need to be designated.
- Discussions should be taking place in regard to partnership representative duties and management responsibilities, which elections should be made, procedures and terms for entry of new partners and exit of former partners.
- Offering memorandums should be updated to disclose the new rules and their effect, including that the partnership, and current partners, could potentially be liable for taxes that relate to prior years.
- Partnership agreements may need to include indemnification provisions for taxes paid and set forth tax sharing provisions describing how taxes or adjustments are allocated among partners. The agreement should also include provisions of how the incentive fee is calculated considering the partnership tax.
- For funds of funds, discussion should take place with regard to requests they may want to make in side letters for investments.
The new partnership audit rules will bring drastic changes to partnerships impacting operations, tax issues, related legal matters, and economic concerns. This synopsis is provided as a brief summary of some of the new partnership audit rules. Keep in mind there are many unanswered questions as well as confusing and overlapping choices, with further technical corrections and final regulations still to come.
MLPs, hedge funds, private equity firms, real estate entities and all businesses structured as a partnership or LLC should be proactive in addressing these issues given the magnitude of the new partnership audit rules. All parties need to sit down and negotiate; there are no grandfather rules. If you are a partner or manager in a partnership now and are not willing or cannot exit or terminate; you are at risk. These rules are of concern now. Deal with the issues in abstract form before they are in actual dispute or controversy. There is still time before the rules are effective. Act now.
Asset Management Intelligence – Q1 2017
- Getting Ready for the New Partnership Audit Regime
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- What U.S. Fund Managers Need To Know when Setting Up an Irish Fund Structure
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- What Your ODD Failed to Identify: Red Flags for Allocators and Investors
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