Peter M. Fass ()
The Bipartisan Budget Act of 2015, Public Law No. 114-74 (Nov. 2, 2015), signed into law on Nov. 2, 2015, has significantly changed the partnership tax audit rules, effective for tax years beginning after Dec. 31, 2017 (Budget Act). Under the current partnership audit rules, after an audit adjustment, the Internal Revenue Service (IRS) must separately assess and collect tax from each partner. See generally IRC §§6221 to 6234. For large partnerships in particular, this can be a lengthy and administratively burdensome process for the IRS. The new rules impose an entity-level tax on a partnership that is subject to an audit adjustment (plus interest and penalties, as applicable). However, partners are not jointly and severally liable for the entire audit tax liability. The partnership is not able to deduct the entity-level tax (or any associated interest or penalties). The partnership’s tax liability initially is calculated by multiplying all net adjustments by the highest marginal federal rate (currently, 39.6 percent).
The partnership may then take certain actions to try to reduce this initial calculation, or the partnership may elect for each of its partners to pay their respective shares of the tax, rather than the partnership itself. In either case, the burden of the partnership audit under the new rules shifts significantly from the IRS to the partnership, which may increase the number of partnership audits by the IRS.
Reducing the initial tax calculation. A partnership’s tax liability can be reduced if (1) partners file amended returns to reflect the partnership’s audit adjustments (for all affected tax years), (2) the partnership demonstrates that adjustments would be allocable either to tax-exempt or non-U.S. partners who would not be taxable on those allocations, (3) the partnership demonstrates that adjustment allocations would benefit from preferential rates (i.e., capital gain or qualified dividend income allocable to an individual or ordinary income allocable to a corporation), or (4) otherwise determined by future guidance.
Election to shift tax payment to partners. A partnership can elect for each of its partners to pay their respective share of the audit tax liability. The partnership must issue a statement to each partner with the information necessary for each partner to calculate such partner’s tax liability resulting from the audit. If the partnership elects this flow-through option, interest and penalties are also assessed at the partner level, but with interest payable at a rate that is 2 percent higher than the generally applicable rate.
Push-Out Election. Under the new rules, a partnership may avoid being liable for the imputed underpayment by electing to push this tax liability out to its partners if the partnership (1) not later than 45 days after the date of the final partnership administrative adjustment (FPAA) elects §6226 of the Budget Acts push-out election, and (2) furnishes to each partner of the partnership for the year audited a statement of the partner’s distributive share of any adjustment to income, gain, loss, deduction, or credit as determined in the FPAA. Each partner’s tax liability for the tax year will be increased by the aggregate of the adjustment amounts determined for the tax years referred to in push-out election.
If a push-out election is validly and timely made, any penalties, additions to tax, or additional amounts are still determined solely on the partnership level, and the partners of the partnership for the audited year will be liable for any such penalties, addition to tax, or additional amounts.
The extent to which partnerships will take advantage of this push-out election is unclear. The decision to pursue the push-out election procedure may depend on the number of adjusted Schedules K-1 the partnership would have to issue, the complexity of preparing those Schedules K-1, the extent to which there has been turnover among the partners, and the magnitude of the tax, penalties, and interest the partnership would otherwise have to bear. Another relevant consideration is that if a partnership elects to pursue the Push-Out Election procedure, thereby shifting any liability to the partners during the year under audit, underpayment interest will accrue at a rate that is two percentage points higher than the otherwise applicable underpayment rate.
Limited ability to opt out of the new rules. Partnerships can elect to opt-out of the new rules if they have 100 or fewer partners consisting exclusively of individuals, corporations or estates. The opt-out may only be made by a partnership with 100 or fewer “eligible partners.” The eligible partner provisions restrict the opt-out to individuals, corporations and estates of deceased partners. Corporations include C corporations, S corporations, foreign corporations, regulated investment companies and real estate investment trusts, along with certain tax-exempt entities classified as corporations under the Internal Revenue Code. Partnerships, trusts, disregarded entities, nominees and other similar persons that hold an interest on behalf of another person are not eligible partners (i.e., no election is available for partnerships having other partnerships or disregarded entities as their partners). Furthermore, only partnerships that are required to provide 100 or fewer K-1 statements for the applicable tax year may opt-out.
Partnership representative to bind all partners. The new rules also repeal the various participation rights and procedural safeguards currently enjoyed by many partners in partnership-level administrative and judicial proceedings. Instead of appointing a tax matters partner, partnerships must designate a partnership representative who need not be a partner but who must have a substantial presence in the United States. The new rules grant the partnership representative the sole authority to act for and bind the partnership (and its partners) in all IRS disputes.
Former partners may escape liability. If a partner transfers his or her interest before a partnership tax audit, the transferee will indirectly bear the burden of any tax liability paid by the partnership, even if the audit was in respect of a prior year. However, if the partnership elects for its partners to pay the tax liability, the transferor will be liable.
Partner Audits and Consistent Reporting. A partnership audit under the new rules is separate from any audit that the IRS may conduct on the partner level for non-partnership items. Moreover, any judicial review of adjustments to a partner’s tax return may not include a review of partnership items because partnership items are solely within the scope of judicial review by the court that has jurisdiction over the partnership adjustment. If it later turns out that partnership items on the Schedule K-1 were incorrectly reported, the partner’s tax return will generally not be reopened to reflect the necessary corrections. Instead, under the general mechanism of the new rules, the corrections flow through to the partner’s Schedule K-1 for the adjustment year.
A partner must, on the partner’s return, treat each item of income, loss, or credit attributable to a partnership in a manner consistent with the treatment of those items on the partnership return. However, a partner may file a tax return that is inconsistent with the partnership tax return if (1) either the partnership has filed a partnership tax return but the partner’s treatment of an item on the partner’s return is (or may be) inconsistent with the treatment of that item in the partnership tax return, or the partnership has not filed a partnership tax return; and (2) the partner properly files with the IRS a statement identifying the inconsistency.
Effective Date and Transition Rules. The new rules apply to partnership tax returns filed for partnership tax years beginning after Dec. 31, 2017. A partnership may elect for the new rules to apply to any partnership tax return filed for partnership tax years beginning after Nov. 2, 2015, and before Jan. 1, 2018.