On November 2, 2015, President Obama signed into law the Bipartisan Budget Act of 2015 (the Act). The Act significantly changes how partnerships (including LLCs taxed as partnerships) are audited by the IRS.
Most non-tax lawyers understand the fundamental difference between the tax treatment of partnerships and corporations for U.S. income tax purposes – i.e., partnerships are "flow-through" entities, whereas corporations are subject to an entity-level tax. As a "flow-through" entity, a partnership allocates its income or loss among the partners each year, which is reported directly on the partners' own tax returns.
Consistent with this principle, traditionally, if a partnership incorrectly reported its income or loss in a given year, the adjustment would "flow through" to the partners in the same year. These partners would then be liable for any deficiency on their own tax returns as revised to include their share of the flow-through adjustment.
For tax years beginning after December 31, 2017, this will no longer be the case. As a result of changes made to the Internal Revenue Code by the Act, partnerships may now be directly liable for any tax deficiency resulting from an adjustment to partnership items (e.g., income, gain, loss deduction and/or credit). Thus, the current partners in a partnership could bear economic responsibility for improper tax reporting in prior years, even if one or more of such partners was not a partner in the year in which the improper reporting occurred.
This change is designed to make it easier for the IRS to assess and collect taxes against partnerships and is expected to raise $9.3 billion in additional revenue over 10 years.
Currently, partnerships are audited under one of three regimes. Which regime applies depends on the size of the partnership, as explained below:
- 10 or Fewer Partners: Partnerships with 10 or fewer partners, each of whom is an individual, C corporation, or estate of a deceased partner, are subject to audit by the procedures that apply to individuals, unless the partnership elects to be subject to TEFRA (defined below).
- More than 10 Partners: Partnerships with more than 10 partners are subject to audit rules introduced by the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). Under TEFRA, partnership items are determined at the partnership level and are then passed through to the individual partners to ensure consistent treatment among the partners. TEFRA requires the partnership to designate a "Tax Matters Partner," who is a partner with authority to act for the partnership in audit proceedings before the IRS.
- 100 or More Partners (Optional ELP Regime): Partnerships with 100 or more partners can elect to apply a streamlined version of TEFRA whereby partnership-level adjustments are taken into account in the year the audit is concluded – so-called Electing Large Partnerships. However, few qualifying partnerships have elected to apply the ELP regime.
Key Aspects of Streamlined Audit Procedures
The Act replaces the existing TEFRA and ELP procedures with new streamlined audit procedures effective for tax years beginning after December 31, 2017. A partnership can elect to apply the new rules earlier. The streamlined audit procedures apply to all partnerships; however, as explained below, certain partnerships with 100 or fewer qualifying partners may elect out of these streamlined audit procedures.
Under the streamlined audit procedures, the IRS will assess and collect taxes from adjustments to partnership items (e.g., income, gain, loss, deduction, and/or credit) at the partnership level in the year the audit is concluded. The amount of tax owed by the partnership will equal the net adjustment multiplied by the highest tax rate (corporate or individual) in effect for the reviewed year. If the adjustment is taxpayer-favorable, it will be taken into account by reducing partnership taxable income or increasing partnership taxable loss, as applicable.
This deficiency computation represents a surprising amount of "rough justice" by IRS standards. Nevertheless, the new rules allow for the partnership to demonstrate that a lower amount of tax is appropriate based on the profile of the partners in the reviewed year (e.g., if some of the partners were tax-exempt or in a tax bracket lower than the highest bracket).
The streamlined audit procedures provide two alternatives to requiring the partnership to pay the adjustment at the entity level:
- Within 45 days after receipt of the notice of final partnership adjustment, the partnership may elect to furnish adjusted Schedule K-1s to each person who was a partner in the "reviewed year" (i.e., the year to which the adjustment relates) with such partner's share of any partnership adjustments. These partners would then take the adjustments into account on their own returns for the current year.
- Alternatively, the partners may self-report the amounts due by filing amended returns for the reviewed year that take into account their share of the adjustment. If one or more partners self-report their share of a proposed adjustment, the imputed underpayment at the partnership level is reduced.
Another important change made by these rules is the elimination of a "Tax Matters Partner." Instead, each partnership must designate a "partnership representative" with substantial presence in the United States (who need not be a partner). The partnership representative shall have sole authority to act on behalf of the partnership in audit proceedings before the IRS. If one is not so designated, the IRS may appoint a partnership representative.
Finally, certain partnerships may elect out of these streamlined audit procedures – specifically, partnerships with 100 or fewer partners consisting solely of individuals, corporations (C or S), and estates of deceased individuals. In other words, partnerships with partnerships or trusts as partners may not opt out of these rules. The opt-out election must be made annually with the partnership's return for such year. If the partnership elects out of the new procedures, the partnership and the partners would be audited under the general rules applicable to individual taxpayers – i.e., the IRS must issue a separate audit report to each partner, and each partner can act independently to challenge its own audit report under the deficiency procedures that otherwise apply to individuals.
Implications for Buyers of Partnership Interests
As a result of these changes, buyers of partnership (or LLC) interests after December 31, 2017 – or earlier if the target partnership has elected early entry into this regime – must be mindful that they could be economically responsible for improper tax reporting that occurred in years before they became partners in the partnership.
If the buyer is purchasing 100% of the outstanding partnership (or LLC) interests, this may not be an issue, because the acquisition of all partnership interests by a single buyer is generally considered a purchase of partnership assets that ends the life of the partnership – and the streamlined audit procedures provide that if the partnership has been extinguished, any adjustment will be taken into account by the former partners of a terminated partnership.
However, if the acquisition does not cause a termination of the partnership (e.g., if the buyer is purchasing less than 100% of the outstanding partnership (or LLC) interests), under the streamlined audit procedures, the buyer will be economically responsible for improper tax reporting that occurred in pre-closing years, unless the aforementioned election is made to require the partners in the reviewed year to bear the cost of the adjustment by delivering adjusted Schedule K-1s to such partners. However, the buyer may not have sufficient control over the partnership to require this election.
Consequently, parties to a purchase and sale of a partnership (or LLC) interest will need to negotiate and document: (i) who will bear the economic cost of partnership-level tax liabilities from pre-closing years assessed post-closing, (ii) who controls the audit examination of pre-closing years, and (iii) the elections the partnership shall be allowed to make.
Moreover, existing partnership agreements should be reviewed to account for these new audit procedures. Particularly for partnerships with high partner turnover, the partnership agreement should specify whether it intends to (A) bear tax liabilities at the partnership level, (B) follow the alternative procedures noted above to pass those liabilities on to the partners of the partnership in the reviewed year, or (C) make this determination on a case-by-case basis.