As part of the Bipartisan Budget Act enacted on November 2, 2015, the procedures for the income tax audit of partnerships, including limited liability companies taxed as partnerships, for U.S. Federal Income Tax purposes will change. The new procedures are elective now and will become mandatory on January 1, 2018. Many partnerships will need to amend provisions of their governing documents to take the change in the law into consideration.
Prior Procedure and History
Pursuant to the provisions of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), partnerships that are subject to an Internal Revenue Service (IRS) audit are audited at the partnership level and the audit is controlled by a "tax matters partner." Under TEFRA, if there is an underpayment of tax, it is assessed and collected from the partners. From 1982 to 2015, there was significant growth in the number of entities taxed as partnerships and an increase in the number of very large partnerships, making the assessment and collection process difficult for the IRS.
New Procedure Under the Bipartisan Budget Act
Under the new system, a partnership income tax audit is conducted at the partnership level and administered by a partnership representative who will have the authority to bind the partnership. The partnership representative will have sole authority to act for the partnership, and it can be any designated person, not just a partner. If a partnership representative is not chosen by the partnership, the IRS will appoint one.
Default Methodology Under the New Statute
Under the new statute, the IRS assesses tax and collects any underpayment from the partnership, not from the partners. The tax is assessed at the highest individual rate. This effectively transfers the tax liability from the partners in the years audited, to the partners in the year that the audit is completed. This tax payment can be reduced if a partner amends its returns for the audited years and pays its share of tax or if the partnership itself can show that it has partners that are either tax exempt entities or are subject to a lower rate of taxation.
Opting Out of the New System
Certain partnerships with 100 or fewer partners can elect out of the new regime. In order for this to happen, the partners must be individuals, estates of deceased partners, S corps, or C corps. They cannot be trusts or other partnerships. If the partnership opts out, the IRS needs to audit the individual partners as opposed to the partnership. Many partnerships will want to put restrictions in their governing documents to prevent partners from transferring their partnership interests to partners that would prevent the partnership from being able to elect to opt out of the new system.
The new statute provides a "push out" election where the partnership can elect to push out the audit adjustments to the partners of the audited years who will then have to amend their returns and pay the tax. To do this, the partnership must issue Form K-1s to all of the partners for the audited years. If this election is made, the partners pay an interest rate on the deficiencies that is two percentage points higher than if the tax were paid at the partnership level.
It is likely that many partnership and LLC agreements will have to be amended to take the following areas into consideration:
- determination of the partnership representative;
- ability of the partnership to elect out of the new statutory scheme;
- restrictions on the transfer of partnership interests to enable the partnership to elect out of the statutory scheme;
- when and if the partnership would make a "push out" election;
- whether there would be "tax distributions" to cover the tax liability from the audit;
- the effect on capital accounts of any taxes paid by the partnership;
- whether tax exempt and low tax rate partners would bear the burden of the tax at the partnership level; and
- other matters as the statutory scheme becomes more clear or is amended.
We Can Help
Please contact a member of Maslon's Tax Group if you have questions or would like to discuss this development.