Looming Partnership Audit Rules Under the New Centralized Partnership Audit Regime
Previously proposed in 2015, the Bipartisan Budget Act includes significant changes to the rules governing federal tax audits of partnerships. After a White House regulatory freeze in January, the recently released new Centralized Partnership Audit Regime establishes new proposed regulations to succeed the cumbersome Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). The new regime is effective for tax years beginning after December 31, 2017, although partnerships can elect to adopt the new regime earlier. Investment partnerships are expected to be particularly impacted by the new audit regime, as it streamlines the audit process, effectively increasing the IRS’ ability to audit and determine payments at the partnership level.
TEFRA was enacted to simplify examinations of partnerships and increase the ability of the IRS to audit large partnerships in one unified proceeding. It was intended to remedy repetitive examinations at the partner level, where each individual partner was dealing separately and directly with the IRS. Instead, the IRS experienced a deficiency in partnership audits as it attempted to apply what some called an inefficient set of audit rules. Additionally, as partnerships increased in size and complexity, audits under TEFRA were inadequate. Another challenge faced by the IRS was, when an adjustment was made at the partnership level, the IRS had to pass it along to the ultimate partners, a difficult and time consuming process. With the complexity of investment partnerships and hedge fund allocations, agreements and tax adjustments, the IRS has historically audited marginally few large investment partnerships.
Centralized Partnership Audit Regime
The new rules are aimed at increasing the rate of partnership audits by reducing the challenges facing the IRS under TEFRA. The scope of the new regime includes all items required to be shown on the partnership return, including adjustments to items of income, gain, deduction, loss or credit, and each partner’s distributive share thereof. Additionally, in a departure from the TEFRA regime, which traditionally passed through items of income and loss to investors, the new regime places the liability on the partnership, which will now be liable for the tax in the year an adjustment is made. The tax is assessed at the highest tax rate in effect at that time for the particular item. Additionally, there are mandatory consistent reporting requirements, partnership level proceedings, and a requirement to designate a representative for proceedings. It is anticipated that state and local revenue agencies will adopt similar rules as they issue updated guidance.
Under the new regime, adjustments are categorized within groups. The three main groupings for partnership audit adjustments include:
- Reallocated items between partners, ignoring negative adjustments.
- Partnership tax credits.
- Remaining items, grouped together according to character, preferences, and other limitations under the Internal Revenue Code, i.e., short-term capital vs. long-term capital, or investment interest and expense.
Partnership adjustments in one group may not offset adjustments in another group. Additionally, within the same group, adjustments from one tax year may not offset adjustments from another tax year. If a tax is assessed and paid by the partnership, it will not be deductible for federal and state purposes. Additionally, Fin 48 calculations may be affected and impact the partnership’s GAAP financial statements. Alternatively to the partnership paying the tax, a partnership may elect to pass down or “push out” adjustments to its partners. If the election is made, the partners in the reviewed year, and not the partnership, will be liable for any taxes assessed.
The updated regime also requires the partnership to designate a representative with substantial presence in the U.S. Under TEFRA, the Tax Matters Partner (TMP) created an authorized designee for the IRS to contact directly, which typically was the general partner. However, the general partner was not always the best choice to handle the partnership’s tax affairs. Under the new guidelines, the representative can be any person including an entity, and need not be a partner. If the partnership designates an entity, the IRS requires an individual to be designated to act on the entity’s behalf. The partnership representative will have the only authority to act on behalf of the partnership binding all of its partners, whereas under TEFRA each partner would handle its individual affairs, despite the IRS inquiry being at the partnership level. In some cases, a non-partner manager would be the best representative, as managers have the books, records, and understanding of the activities of the partnership.
The representative is designated on the partnership’s return filed for that year. It is done separately for each year and, once designated, cannot be revoked until the IRS issues a notice of administrative proceeding. Consequently, it may be necessary to edit the partnership’s governing documents to account for this. In the case that no representative is chosen, the IRS will notify the partnership and give it 30 days to choose one. If none is chosen, the IRS will designate a representative. Once chosen by the IRS, the partnership may not revoke it without IRS consent.
Partnerships have the opportunity to elect out of the new centralized audit rules whereas previous TEFRA rules mandated that entities with 10 or more investors be subject to TEFRA. Partnerships eligible to opt out are partnerships with fewer than 101 partners who are all eligible, defined as C corporations (including foreign corporations, RICs and REITs), S corporations, eligible foreign entities, individuals, and the estate of a deceased partner. If a partnership has partners which are disregarded entities, trusts, or other partnerships, it is ineligible to opt out.
It is important to note that S Corporations, also issuing Schedule K-1s to investors, are subject to combinable look-through rules. This means that an S Corporation’s total investor Schedule K-1 count tallies towards the total of the partnership in which it is invested. If a partnership chooses to opt out, the IRS intends to carefully review its decision to ensure it is not merely trying to frustrate compliance. The partnership must inform its investors of its decision to opt out. The opt-out election is made annually with the partnership tax return. Partnerships which elect out are subject to the pre-TEFRA audit procedures under which the IRS must separately assess tax to each partner individually.
An unintended consequence of the new regime is that partners may be limited in their ability to transfer or sell their partnership interests. Incoming partners may fear the economic responsibility of being assessed an audit adjustment from a prior year. Potential investors should perform due diligence to ensure they will not pay for prior year errors. To minimize this, investors may request side letters asking the partnership indemnify them, opt out, or push down any adjustments made.
Please contact your Marcum LLP tax advisor to discuss planning opportunities related to this matter.