This blog post is intended to identify the most material aspects of the proposed regulations the IRS has introduced to implement the BBA partnership audit rules, and provide guidance on what actions a partnership should consider taking at this time.
The proposed regulations (REG-136118-15) consists of a 157-page preamble and 120 pages of regulations; this blog post seeks only to highlight the regulations, rather than provide a comprehensive summary.
As discussed in a previous blog post, Congress enacted the Bipartisan Budget Act (the “BBA”) in 2015, which completely revamped the way partnerships (including LLCs taxed as partnerships) will be audited, beginning January 1, 2018. Since the introduction of the BBA, tax professionals have discovered a vast number of problems with the new audit regime and the administrative strain it will place on partnerships.
In response to the BBA, on December 6, 2016, Congress introduced the Technical Corrections Act of 2016 (the “TCA”) to address a number of these concerns, which are summarized here.). The TCA expired on January 3, 2017, but is expected to be re-introduced.
On January 18, 2017, the IRS published proposed BBA regulations, but the regulations were frozen by the Trump administration. The regulations have since been re-issued on June 18, 2017, and are summarized in this blog post.
Designating Partnership Representative
Replacing the “Tax Matters Partner,” the proposed regulations require a partnership to have a “Partnership Representative” to act on the partnership’s behalf. The Partnership Representative may be an individual or an entity, but must have a substantial presence in the U.S. and have the capacity to act.
If a partnership designates an entity as Partnership Representative, the partnership must identify an individual to act on the entity’s behalf. The Partnership Representative is designated on the partnership’s return filed for the taxable year. The designation must be made every year, as a designation for one year is not effective for any other year. If no Partnership Representative is designated, the IRS may select any person to serve as Partnership Representative.
A Partnership Representative shall serve until the earlier of resignation, revocation, or until the IRS determines a designation is not in effect. The designation may not be changed by the partnership until the IRS issues a notice of administrative proceeding (unless the partnership files an administrative adjustment request as discussed later in this memo).
However, the regulations do appear to allow a partnership to appoint a new partnership representative upon the resignation of the current partnership representative, therefore a partnership may seek authority to compel the representative to resign, thus allowing the partnership the power to replace the partnership representative at any time.
The Partnership Representative has very broad powers, including the sole authority to bind the partnership and all the partners in any action with the IRS, including agreeing to settlements, agreeing to a notice of final partnership adjustment, making a push-through election (as discussed later in this post), and agreeing to extend the period for adjustments. This authority may not be limited by state law or by any agreement between the partners (e.g. a partnership or operating agreement).
Electing Out of the BBA Audit Regime
Certain partnerships may elect out of the new audit regime and continue to be governed by the current TEFRA procedures which provide for audits at the partner-level (as described in an earlier post). The proposed regulations provide clarity with respect to partnerships that may elect out of the new audit regime. Only an eligible partnership may elect out of the BBA audit regime. An eligible partnership is a partnership that (i) has 100 or fewer partners, and (ii) all partners are eligible partners.
- (i) 100 or Fewer Partners - a partnership has 100 or fewer partners if it is required to furnish 100 or fewer statements (i.e. Schedule K-1’s) during the year. For purposes of determining eligibility to elect out, also included in the 100-statement limit are any statements furnished by any partner that is an S-corporation to its shareholders.
- (ii) Eligible Partners - an “eligible partner” is any person who is an individual, C corporation, S corporation, estate of a deceased partner, or an eligible foreign entity. Eligible partners do not include partnerships, trusts, disregarded entities, estates that are not estates of a deceased partner, and foreign entities that are not eligible foreign entities.
A partnership may only elect out on a timely filed partnership return (including extensions). Therefore, a partnership may not elect out for the taxable year if a return is filed after the due date.
Second, a partnership electing out must provide the IRS with the names, TINs, and federal tax classifications of all partners and, if any partner is an S corporation, the same information for all shareholders of such S corporation.
Lastly, the partnership must notify each of its partners within 30 days that the partnership has made the election. The preamble to the proposed regulations state that the IRS intends to carefully review partnership elections, so a partnership must be sure to strictly comply with the requirements set forth in the regulations.
The BBA rules and regulations substantially change the payment of any tax liabilities resulting from an audit. If after a proceeding the IRS determines partnership adjustments that ultimately result in an imputed underpayment of tax, the general rule is that the partnership must pay the imputed underpayment in the year of adjustment. An imputed underpayment is calculated by multiplying the total netted partnership adjustments by the highest rate of federal income tax in effect for the reviewed year, and is adjusted by any changes in the partnership’s credits. If the partnership disagrees with the determination of an imputed underpayment, the partnership may request modification of the amount, as discussed later in this section.
Modification may be requested for several enumerated reasons, including the following most common scenarios:
- Amended Returns: if a reviewed year partner (or indirect partner) files one or more amended returns that take into account the relevant portion of the partnership adjustment, and concurrently makes any resulting payment arising from the amended return.
- Tax-Exempt Partners: based on the tax-exempt status of any of its partners.
- Rate Modification: by requesting and demonstrating that a lower tax rate would apply to all or portions of the total netted partnership adjustment allocable to a C corporation or an individual.
“Push-Out” Alternative to Paying Imputed Underpayment
After being assessed an adjustment, a partnership may elect to “push-out” the adjustment to its reviewed year partners rather than paying the imputed underpayment at the partnership level. Upon making a valid push-out election, the reviewed year partners become liable, on a pro rata basis, for any tax, penalties, and interest after taking into account their share of the partnership adjustments. A partnership has 45 days from the final partnership adjustment to make the push-out election. The election must be signed by the Partnership Representative and filed with the IRS. A push-out election binds all reviewed year partners.
To make a valid push-out election, the partnership must furnish statements to the reviewed year partners within 60 days after the final partnership adjustment and file the statements electronically with the IRS. These statements identify each partner’s share of the adjustments and are in addition to, and are filed and furnished separate from, any other statements issued to partners (i.e. Schedule K-1’s), and the adjustments should not be taken into account on any Schedule K-1.
A partner that is furnished a statement resulting from a push-out election may elect to pay a safe harbor amount shown on the statement in lieu of paying the additional reporting year tax. The safe harbor is intended to provide a simplified method for the reviewed year partner to take into account the partner’s share of adjustments, and represents a reasonable alternative to approximate the tax that would have been due in the reviewed year. The safe harbor provides a straightforward option for partners that decide that the complexity and cost of calculating the correct, exact amounts due is not worth the effort. The calculation of the safe harbor amount is beyond the scope of this memo.
The TCA provided that partners who are themselves a flow-through entity could further push-out any adjustments described in this Section. However, the IRS has identified a number of administrative pitfalls with this option, and therefore, in the proposed regulations, has merely added a placeholder for the issue, with substantive regulations to follow.
Administrative Adjustment Requests
The proposed regulations lastly provide that partnerships may self-report adjustments by filing an administrative adjustment request (“AAR”). A partnership may file an AAR with respect to one or more items of income, gain, loss, deduction, or credit, and any distributive share of such items.
What Partnerships Can Do Now
Existing partnerships should consider several actions in response to the new partnership audit regime and the proposed regulations. As a threshold matter, partnerships must determine prior to the due date of their 2018 tax returns whether or not to elect out of the new audit regime, if eligible (keeping in mind that this election does not carry over, and must be made separately for each subsequent year).
If a partnership is not eligible to elect out, or chooses not to elect out, the partnership should review its governing documents prior to December 31, 2017, to determine if it should amend its governing documents to account for the new audit regime.
At the very least, the partnership must determine how it will appoint and remove a partnership representative, and specify the authority and notice obligations of the partnership representative, as well as provide for any indemnity to the partnership representative. The partnership should also identify its recourse if the partnership representative acts beyond its authority or as directed by the partnership.
Partnerships subject to the new audit regime must also determine whether the partnership or the partners will directly bear the tax consequences of an adjustment, including whether the partnership will be responsible for such costs (with current year partners bearing such costs indirectly), or whether the partnership will push-out adjustments, require partners to file amended returns in response to adjustments, or require partners to contribute to the partnership a pro rata share of an adjustment taken at the partnership level. The partnership should also require cooperation by the partners in seeking any modification of an adjustment and in complying with the BBA.
Lastly, the BBA will impact transactions involving partnership interests. In a purchase or sale of partnership interests, the transacting parties should include provisions addressing the new audit regime, as an acquiring partner could become directly or indirectly liable for an underpayment that occurred during a year prior to becoming a partner.
1 Prop. Reg. § 301.6223-1.
2 Prop. Reg. § 301.6223-1(b)(2)-(4).
4 Prop. Reg. § 301.6223-1(c).
6 Prop. Reg. § 301.6223-1(f)(1).
7 Prop. Reg. § 301.6223-1(e)(2).
8 Prop. Reg. § 301.6223-2.
9 Prop. Reg. § 301.6223-2(c)(1).
10 Prop. Reg. § 301.6221(b)-1(b).
12 Prop. Reg. § 301.6221(b)-1(b)(2).
13 Prop. Reg. § 301.6221(b)-1(b)(2)(ii).
14 Prop. Reg. § 301.6221(b)-1(b)(3)(i).
15 Prop. Reg. § 301.6221(b)-1(b)(3)(ii).
16 Prop. Reg. § 301.6221(b)-1(c)(1).
17 Prop. Reg. § 301.6221(b)-1(c)(3).
18 Prop. Reg. § 301.6225-1(a).
19 Prop. Reg. § 301.6225-1(c)(1).
20 Prop. Reg. § 301.6225-2.
21 Prop. Reg. § 301.6225-2(d)(2)(i).
22 Prop. Reg. § 301.6225-2(d)(3).
23 Prop. Reg. § 301.6225-2(c)(4).
24 Prop. Reg. § 301.6226-1.
25 Prop. Reg. § 301.6226-1(b)(1).
26 Prop. Reg. § 301.6226-1(c)(3).
27 Prop. Reg. § 301.6226-1(c)(4)(i).
28 Prop. Reg. § 301.6226-1(c).
29 Prop. Reg. § 301.6226-3(c).
30 Prop. Reg. § 301.6227-1(a).