With the Bipartisan Budget Act of 2015, H.R. 1314 (the “Act”), enacted on November 2, 2015, Congress has introduced some major changes affecting partnerships (including LLCs taxed as partnerships), replacing the current Tax Equity and Financial Responsibility Act (“TEFRA”) partnership IRS audit rules. Generally, the Act provides new rules designed to make it easier for the IRS to conduct partnership audits and collect any tax liability by collecting partnership-level income tax deficiencies from the partnership, rather than from the partners themselves.
Currently, partnerships are audited based on the size of the partnership. Audits range from review of the individual partners’ returns along with the partnership, to a review only at the partnership level. The Act seeks to impose partnership-level review on large partnerships, and also allow for other partnerships to elect this treatment as well.
A. To whom do the Act’s new rules apply?
The Act’s new rules apply to any partnership, regardless of size, that does not elect out of the rules. Only partnerships with 100 or fewer partners (i.e. issue 100 or fewer K-1s), and whose partners do not include any partnership or trust, may elect out of the new partnership audit rules. The partnership must make the election annually on its partnership return, and notify all partners of the election.
B. What changes to the rules are contained in the Act?
The Act creates a new audit regime under which the IRS generally will:
- conduct audits and make any adjustments at the partnership level
- impose any tax deficiency at the partnership level, rather than on the partners, at the highest individual or corporate tax rate in effect
- impose any such deficiency for the year under audit in the year of the adjustment, rather than impose the deficiency in the year under audit.
The IRS is to prescribe rules allowing a partnership to reduce the tax liability by showing that some of its partners are subject to a lower tax rate or are tax-exempt.
Rather than taking a tax adjustment at the partnership-level, partnerships will have the option to elect to pass through any adjustment items to the partners by issuing adjustment statements to each partner, which are then taken into account by the partners on their own returns in the year the statement is received.
Partnerships will also be able to self-report adjustment items, and take such items into account in the adjustment year at either the partnership level, or by providing amended K-1s to the partners. To make such an adjustment, the partnership must file with the IRS an administrative adjustment request.
The Act replaces the point of contact for tax matters, previously called the “tax matters partner,” with a “partnership representative.” The partnership representative assumes sole authority to act for the partnership in an audit and is the sole point of contact for all IRS communications and notices. Actions taken by the partnership representative and any final decision in a proceeding with respect to the partnership will now be binding on the partnership and its partners. The partnership representative need not be a partner, but rather must only have a substantial presence in the United States.
The rule changes may also concern partnerships with respect to merger and acquisition activity. Transaction parties will need to consider who should bear the risk of post-closing audits for pre-closing tax years, who will control such audits, and what elections the partnership will be allowed to make.
C. When do the changes take effect?
The Act’s new rules become effective for partnership tax years beginning after December 31, 2017. For a calendar-year partnership, this means the 2018 tax year is the first year under the new rules. Partnerships may elect to have the Act’s new rules to apply sooner. The form and manner for making such an election are yet to be prescribed.
D. How can a partnership address today the changes that will take effect?
Small partnerships (less than 100 partners) should start determining whether they will choose to elect out of the new audit rules. Partnerships that do not elect out or that are ineligible to elect out (those with more than 100 partners) will need to amend their operating agreements to address the new requirements, such as designating a partnership representative, and deciding whether the partnership will pass-through audit adjustments to the partners by issuing adjustment statements or not. The partnership must also address the issue of partners withdrawing from the partnership and the corresponding tax implications.
The Act represents only the beginning of the rulemaking process. The IRS is now tasked with laying out regulations that will provide partnerships with the necessary information on how to address the new rules. The new regulations will set forth, among many other things, how to elect a deficiency pass-through, what type of informational statements to provide, how to appoint a partnership representative, and how to request an administrative adjustment. Currently, there is no specific timetable stating when these regulations will be issued. Partnerships must stay informed as the regulations develop, and amend their governing documents as soon as possible after the regulations are released.