New partnership audit rules enacted into law on November 2, 2015 (the “Centralized Partnership Audit Rules”) (previously discussed in our QuickStudy: Bipartisan Budget Act of 2015 Changes Audit Rules for Private Equity and Hedge Funds) generally require all determinations of adjustments to income and payments of tax pursuant to a partnership tax audit, which have historically been imposed on the partners, to instead be made at the partnership level. The Centralized Partnership Audit Rules generally apply to all partnerships (and all entities taxable as partnerships) for all taxable years beginning after December 31, 2017, and any partnerships that elect to apply the Centralized Partnership Audit Rules for taxable years between November 2, 2015, and January 1, 2018.
The IRS originally issued proposed regulations (REG 136118-15) (the “Proposed Regulations”) on January 18, 2017 related to the Centralized Partnership Audit Rules. However, on January 20, 2017, President Trump directed regulations that had been sent to the Office of the Federal Register, but not yet published, to be immediately withdrawn for further review. The Proposed Regulations had not yet been published in the Federal Register and therefore were withdrawn in order to comply with the President’s directive. On June 13, 2017 the IRS re-released the Proposed Regulations. The Proposed Regulations are lengthy (over 250 pages) and this Quick Study is intended to summarize a few of the most important provisions.
Partnerships with 100 or fewer partners may elect out of the Centralized Partnership Audit Rules. In order to qualify, each of the partners of the electing partnership must be an individual, C corporation, S corporation (although there is a special flow-through counting rule for S corporation partners), or the estate of a deceased partner. Notably, partnerships with partners which are partnerships are not eligible for this election. For example, in a tiered partnership structure where Partnership X has Partnership Y as a partner, Partnership X would not be eligible to elect out of the Centralized Partnership Audit Rules. The name and taxpayer identification number of each partner must be disclosed. This election must be made every year and the partnership must notify each partner that the election has been made.
For partnerships that are not eligible to elect out, under the Proposed Regulations, the amount of tax the partners owe due to audit adjustments (“imputed underpayment”) is assessed and collected at the partnership level. The partnership pays in the “adjustment year,” which is the taxable year the audit determination becomes final, the taxes owed in the “reviewed year,” which is the taxable year to which the imputed underpayment relates. Thus, the partners of the partnership in the adjustment year effectively bear the economic burden of the tax owed by partners of the partnership in the reviewed year. This may be acceptable if the partners and their interests in the partnership are identical in both years, but unacceptable when partners and/or interests vary from year to year. For example, assume X and Y are equal partners in Partnership A. In 2020 Partnership A reports $100 of income, in 2021 Y transfers its interest in Partnership A to Z, and in 2022 (the adjustment year) the IRS determines Partnership A’s income in 2020 (the reviewed year) was $200. While historically X and Y would be responsible for the $100 underpayment from 2020 and the IRS would assess X and Y for the underpayment as individuals, under the Centralized Partnership Audit Rules and the Proposed Regulations, Partnership A is responsible for the $100 underpayment in 2022 (the adjustment year). The economic burden will therefore fall to X and Z, the partners in Partnership A in 2022.
The default imputed underpayment amount described above is calculated by (i) netting all adjustments to income, gain, loss and deduction, (ii) multiplying that amount by the highest applicable federal tax rate for the reviewed year, and (iii) reducing or increasing that number for any adjustments to tax credits. The highest applicable federal tax rate for the reviewed year is 39.6% but can be modified with respect to any portion of an imputed underpayment if the partnership is able to demonstrate that the portion of the imputed underpayment is allocable to a partner that is a C corporation or, in the case of a capital gain or qualified dividend, is an individual. However, the applicable rate can never be modified to be lower than the highest rate in effect for the reviewed year with respect to the character of the income (i.e., ordinary or capital gain) and the status of the taxpayer (i.e., a C corporation or an individual). The Proposed Regulations also set forth procedures for modifying the default imputed underpayment amount – for example, the imputed underpayment can be reduced by taking into account the portion of the adjustment that is allocable to a tax-exempt partner, or modified to take into account a closing agreement entered into by the IRS and any partner.
Partnerships that do not qualify for the small partnership exception may make an election to push out the partnership’s tax liability to the partners for the reviewed year (instead of the partners for the adjusted year). A partnership that validly makes this election is no longer liable for the imputed underpayment to which the election applies. When such an election is made, the partnership is required to provide a statement similar to a K-1 to each reviewed year partner and the IRS, showing each partner’s share of adjusted items. The name and taxpayer identification number of each partner must be disclosed. Audit adjustments are taken into account as an adjustment to the tax liability of the partner for the year in which the statement is received, and tax is calculated by reference to the amount the adjustment would have increased the tax liability of the partner in the reviewed year. If this election is made, the interest rate imposed on the imputed underpayment at the partner level is two percentage points higher than if the imputed underpayment is paid by the partnership. Thus, if the interest rate for an imputed underpayment is 5%, the interest rate once the push out election is made is 7%. The Proposed Regulations do not provide any guidance regarding how this push out election works where a partner is itself a partnership.
Under the Proposed Regulations, the partnership must designate a “Partnership Representative” to interface with the IRS in audit proceedings. The Partnership Representative replaces the former partnership audit regime’s Tax Matters Partner, but the Partnership Representative has more extensive powers than the Tax Matters Partner under the prior regime. Partners are bound by actions taken by the Partnership Representative, and have no statutory right to notice of, or to participate in, tax audits or litigation. If the partnership neglects to properly designate a Partnership Representative, the Proposed Regulations set forth procedures for the IRS to designate a Partnership Representative for the partnership.
Prior to the Centralized Partnership Audit Rules effective date of January 1, 2018, partnerships will need to update their partnership agreements to designate a Partnership Representative. Partnerships may also want to consider adding provisions requiring partners to indemnify the partnership for their share of any tax liability for a reviewed year, even if the partner is no longer a partner in the partnership during the adjustment year. Most partnerships have been waiting for more definitive guidance before amending their partnership agreements. The recent re-release of the Proposed Regulations just several months before the effective date of the Centralized Partnership Audit Rules means partnerships will need to move quickly to prepare for the new regime.