On November 2, 2015 the Bipartisan Budget Act of 2015 (the “Act”) was enacted, completely transforming partnership audit procedures going forward. The intent was to streamline audit procedures and increase partnership tax compliance. The effect is going to be a lot more scrutiny related to tax terms in partnership agreements , tax issues in partnership mergers and acquisitions, and analyses of tax liability related to individual purchases or transfers of partnership interests.
Although we have some time until these new rules apply to partnerships, the next two years are going to be busy as the Treasury Department provides additional guidance and procedures, and partnerships, partners, and prospective partners work to tailor their agreements to protect themselves from liabilities as a result of the new Act.
The Act is applicable to taxable years beginning after December 31, 2017, unless a partnership elects to apply the rules earlier.
Who Pays the Partnership Tax Adjustment ?
Under existing audit rules, if a partnership is audited, those persons who were partners in the year being audited (the Reviewed Year) are responsible for any tax deficiency determined on audit. However, under the new Act the partnership itself will be required to pay any amount due. The tax will be calculated at the highest marginal tax rate and will not be offset by any partner level items. This means that partners in the Reviewed Year benefited from the now-disallowed deductions, and partners in the year of assessment (the Adjustment Year) take the hit as a partnership cost.
There will be two ways a partnership could get out of this partner level treatment for past taxes. First, the Act directs the Treasury Department to promulgate rules and procedures for the partnership to have the partners from the Reviewed Years pay for the adjustment, known as a Partner Assessment Election . The partnership can make the Partner Assessment Election within 45 days after the date of the partnership’s receipt of notice of a final partnership adjustment. Second, small partnerships with less than 100 partners, and no partnerships (or LLCs taxed as partnerships) as partners, may opt out of the new audit rules; this is known as the Small Partnership Election . To qualify for the Small Partnership Election all of the partners must be individuals, C corporations, S corporations or an estate of a deceased partner, and the name of each partner and their taxpayer identification number must be disclosed to the IRS in order to make the election.
If a partnership makes a Partner Assessment Election, and shifts the burden of payment for an adjustment to the partners in the Reviewed Year, those partners will have to compute the impact of the adjustment on their tax liability for the Reviewed Year. However, instead of amending that tax return, they will have to pay the tax increase with their tax returns for the Adjustment Year, plus interest on the partnership-related tax at a rate 2% higher than the normal underpayment rate. If the partnership does not have a tax increase, but has a decrease, those partners don’t get to claim the benefit on their own returns. Instead, the benefit is treated as a partnership deduction for the Adjustment Year.
Prospective purchasers of partnership interest should consider:
- Carefully reviewing prior period tax returns for any potential liabilities.
- Requesting an indemnification from the seller for any losses suffered by them as a result of an audit related to a pre-purchase date taxable period, if a Small Partnership Election has not or cannot be made.
- Requesting the Small Partnership Election be made if the partnership is eligible, keeping in mind that electing out of the new Act means that all partnership issues will be examined and adjusted in multiple partner-level deficiency proceedings.
- Requesting a representation that no election has been made to apply the Act to taxable periods beginning before 2018.
Partners should consider amending their partnership agreements to:
- Require the partnership to maintain the necessary records,
- Require the partnership to make Partner Assessment Elections for all relevant periods, and
- Prohibit any partnership from becoming a partner.
Partnerships with partnerships as partners should consider eliminating those partnerships.
Statute of Limitations:
Under the new Act, the filing date of a partner’s tax return is no longer relevant to a partnership audit unless the Small Partnership Election is made, or the partnership is terminated. Instead, the statute of limitations will be three years from either the due date of the partnership tax return (without extensions) or the filing of the partnership’s tax return, whichever is later.
Tax Matters Partner :
Currently, each partnership ( or LLC taxed as a partnership ) must have one partner that is chosen to be the Tax Matters Partner to be the contact person for the IRS in the event of a partnership audit. However, the other partners still have statutory rights to notice of, or participation in, any audit of the partnership. Under the new Act, instead of a Tax Matters Partner, each partnership will have a Partnership Representative. The Partnership Representative does not have to be a partner of the partnership, but must have a substantial presence in the United States. This person would have authority to resolve a partnership audit, and that resolution would be binding on all partners. Other partners will have no statutory rights to participate in tax audits or litigation or to opt out of the partnership-level proceedings. If the partnership does not select a Partnership Representative, the IRS may appoint any person to represent the partnership.
As a result, existing partners and potential purchasers should consider rules for appointing or electing their Partnership Representative, and for obtaining additional notice and participation rights regarding the actions of the Partnership Representative. This could be done in the purchase agreement and in the partnership agreement.
If you are a partner in a partnership, don’t wait. 2018 will be here before you know it, so now is the perfect time to take a closer look at your partnership agreement to determine whether you want to make changes in anticipation of the new Act. And, if you are considering becoming a partner in an existing partnership, your due diligence list just got longer. Make sure you have a qualified accountant assist you in the review of the partnerships past tax returns that are still subject to audit, and that your legal counsel is knowledgeable about the new Act and can protect you accordingly.
The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.