A heads up on the Bipartisan Budget Act of 2015. This Act makes major changes to IRS audits of entities taxed as partnerships. This discussion focuses on partnerships, but it applies to entities such as limited liability companies that are taxed as partnerships. While these provisions are effective for partnership tax years beginning after 2017, partnerships may elect to have the rules apply to tax years beginning after November 2, 2015. The old rules from 1982 are cumbersome for the IRS and this new regime for partnership adjustments and audits is focused on partnership-level adjustments and assessments. To put the changes in perspective, the new rules are estimated to generate $10 billion in additional tax revenue—enough to feed a lot of chickens! The revenue will largely be raised by making it easier for the IRS to audit partnerships and to collect assessments made as a result of such audits. The default rule is that the partnership is assessed the tax liability on the “Imputed Underpayment Amount” based on the highest applicable federal income tax rate. However, there are certain elections that change the general rule. The “Imputed Underpayment Amount” is the net non-favorable adjustments to the partnership tax year under review/audit multiplied by the highest applicable tax rates under Sections 1 (individuals) or 11 (corporations) of the Internal Revenue Code. Interestingly, the adjustment year is later than the reviewed year. It generally is the year in which the audit becomes final. For example, if the IRS starts auditing the 2018 tax year in 2020 and the audit changes are agreed to in 2021, then the reviewed year is 2018 but the adjustment year is 2021 and it is 2021 for which the assessment is made.
The partners are bound by the final resolution at the partnership level. Only the partnership-level statute of limitations is relevant—a partner’s statute of limitations is no longer taken into account. Any penalties are determined at the partnership level. There are no partner level defenses to penalties. Each partnership must designate a “Partnership Representative,” who does not need to be a partner in the partnership. But the Partnership Representative must be a person (an individual, trust, estate, partnership, association, company or corporation) with a substantial U.S. presence. If the partnership does not designate a Partnership Representative, then the IRS will appoint one. From a drafting standpoint, who the Partnership Representative will be and how such person can be removed becomes very important. Similarly, the obligation of the Partnership Representative to communicate with the partners about the audit and assessment is important. Further, should the partners be given authority to compel the Partnership Representative to make certain elections to move away from the default rule?
One of the elections out of the default rule allows partners to pay the tax (and not the partnership). How is this treated for capital account purposes? The Imputed Underpayment Amount at the partnership level can be reduced by partners who were partners during the reviewed year filing amended returns taking into account their distributive share of the partnership adjustments and paying the applicable tax. But how will the partnership know this? Does the partner filing the amended return have to furnish a copy of the return to the Partnership Representative? Does the partnership agreement attempt to protect the confidentiality of such amended return?
Another election by the partnership allows it issue partnership “statements” (essentially amended K-1s) to the partners who were partners during the reviewed year. This makes the partners subject to the tax and any related penalties in the year of the statement (and not the reviewed year). Because of the delay between the reviewed year and the statement year, there is a 2% higher interest rate than would typically be charged. Further, the partners have no right to an administrative or judicial review. Rather, they are bound by this partnership-level determination. This is another illustration of the importance of drafting the partnership agreement. Should there be internal procedures to determine the whether or not to make the election? Should the partnership agreement require partners and former partners to provide the partnership with information required by the election?
If the partnership pays the taxes, should partners (both current and former) be obligated to pay the partnership for their share of the liability? And how should tax-exempt partners be treated? Under procedures to be adopted, the partnership can submit evidence to show that certain partners are tax-exempt entities. But what if the income would be taxable to the tax-exempt partner as unrelated business income?
As the above shows, Congress’ attempt to raise $10 billion by making it easier on the IRS to audit partnerships and to collect assessments raises many questions for partnerships and their partners. It is a new world that will take considerable thought and careful drafting. Fortunately, the effective date is for partnership tax years beginning after 2017. But steps can be taken now, such as naming the Partnership Representative and providing some procedures for dealing with the issues that are bound to arise.
If you would like more information about this topic, or other legal issues, please contact a member of our Tax, Estate Planning and Employee Benefits Group 208.344.6000.