The centralized partnership audit regime enacted by the Bipartisan Budget Act (BBA) adds important tax considerations for buyers acquiring partnership interests or the equity of an LLC taxed as a partnership in an M&A transaction. Due diligence has taken on increased importance as the BBA can impose successor liability at the partnership level based on the entity’s pre-acquisition liabilities.
Historically, buyers and sellers of entities taxed as partnerships limited inquiries made in the diligence process because the liability for pre-transaction federal income tax issues of the partnership stayed with the sellers after a transaction. However, the BBA audit rules allow for assessment of deficiencies against the buyers rather than the historical members or partners, creating potential entity level tax consequences for the 2018 tax year and beyond. Further, some taxpayers may have previously elected into partnership level assessment for 2016 and 2017, prior to when the BBA audit rules switched to an “election out” program in 2018, discussed below.
Among the significant aspects of the BBA, the IRS is now empowered to collect tax underpayments directly from a partnership. These changes may result in acquirers of partnership interests inheriting entity-level tax liabilities that would have historically been the responsibility of the partnership’s historical partners. Accordingly, prospective buyers should be wary of understatements of a target partnership’s taxable income in years subject to the BBA and take steps to shield themselves from potential successor liability or unexpected capital shifts from the impact of these changes.
The BBA gives buyers or contemplative owners of entities taxed as partnerships (i.e. LLC, LLP, and other unincorporated entities) cause for concern, as well as new opportunities for planning. Understanding these rules and how to navigate them has become an essential element for acquiring into and operating in partnership tax solution, and care should be taken in the proper structuring of an acquisition. Changes to the historical normative buy-sell documents and operating agreements are required to address the changes in the law, and further due diligence procedures will need to be performed going forward to identify potential exposures and structuring opportunities created by the new law.
The BBA partnership audit rules replace the old rules implemented by the Tax Equity and Fiscal Responsibility Act (TEFRA) for tax years beginning after Dec. 31, 2017. Under the BBA, many partnerships are subject to an entity-level audit by default. A partnership may opt out of the BBA audit procedures only under limited circumstances, including special rules for partners that are S corporations. A valid election out of partnership-level audit shifts the determination of any adjustments to the partner level. The partnership is required to notify each partner of the election being made. Valid elections are effective only for the year in which it was made, and an eligible partnership must file an election annually to maintain its exempt status from entity-level audit for the respective tax year. Accordingly, compliance procedures should include annual review of these rules, and due diligence procedures should include a review of the prior elections related to the BBA historically.
Additionally, the BBA repeals the “tax matters partner” role, instead requiring a partnership to designate a “partnership representative” (PR). The PR can be any individual or entity that has a substantial presence in the United States. The PR has sole authority to act on the partnership’s behalf, and any action taken by the PR is binding on all partners. This means that designating the PR at the time of entering into a partnership or operating agreement or acquisition is incredibly important. The parties to an acquisition should ensure that transaction closing documents contain provisions that detail the application of the rules and each party’s roles, indemnities and responsibilities. Without care, an acquirer may find in the event of an audit that they have limited control in the handling of choices made during the audit.
If the IRS makes an adjustment to the partnership return in a BBA audit, it may assess an “imputed underpayment,” which is determined by calculating a tax-effected amount based on the proposed adjustments, subject to certain modifications. Most notably, the BBA, unlike TEFRA, allows the IRS to collect the imputed tax underpayment as well as any penalties and interest directly from the partnership. In other words, the BBA places the burden of paying for any tax deficiencies on the partnership as of the time of assessment unless the partnership makes a “push-out election.” A valid push-out election results in any adjustments being due at the partner level, subject to an additional interest charge.
A push-out election is valid if it is made within 45 days of the date of the notice of final partnership adjustment and the partnership issues a statement of the partner’s share of the final partnership adjustment (i.e., an adjusted Schedule K-1) to the IRS and to each partner as of the reviewed year(s). Generally, once a valid push-out election is made, the partners must pay the underpayment on their current-year returns. If a partnership does not make a push-out election, it can still reduce the imputed tax underpayment amount by showing that at least one partner 1) has filed an amended return accounting for his share of the final partnership adjustment and pays any tax due; 2) is tax-exempt; or 3) is subject to a lower tax rate.
For example, consider a buyer that acquires a target LLC in 2020 that was previously taxed as a partnership and the target LLC becomes a wholly-owned subsidiary of the buyer or its holding company. If the IRS audits the LLC, and the audit results in an assessment for an adjustment, then the buyer who now owns the LLC may have primary financial responsibility for payment of the assessment from the LLC at the entity level. However, if the buyer has the ability to make the push-out election or can otherwise demonstrate mitigating factors, the assessment from the LLC may be reduced. It is possible that further consideration may be required with respect to partnership allocation matters as a result of audit adjustments.
Buyers should consider the BBA’s effect on the partnership audit rules in any future acquisition of a partnership interest or an entity taxed as a partnership. Buyers should be especially mindful of the shift to entity-level assessment under the BBA because a buyer can inherit liability for any pre-acquisition tax deficiencies determined in a BBA audit, even if the partnership terminates as a result of the acquisition (i.e., if the acquisition is structured as a Rev. Rul. 99-6 transaction). Moving forward, buyers seeking to acquire a partnership interest should consider taking the following steps to protect against successor liability:
- Review the target partnership’s records to determine potential understatements of taxable income in years subject to the BBA audit regime
- If possible, require the target partnership to opt out of the BBA audit procedures for tax years beginning prior to acquisition where the return will be filed after the acquisition
- Obtain the appropriate indemnifications from the seller(s) for any pre-acquisition tax liabilities, including liability imposed under the BBA
Sellers should also consider similar steps that can be taken to improve negotiating power in an acquisition. Finally, as always, buyers and sellers should consult with a tax professional to find the best strategy to mitigate any tax exposures.
To learn more visit gt.com/tax
Melanie K. Krygier
Melanie is a Partner, leading our M&A Tax Services practice for the West Region, with more than fourteen years of experience serving public and private multinational companies across multiple industries.
San Francisco, California
- Mergers and acquisitions tax services
s here Qualifications Tracy is a Partner in Grant Thornton’s Mergers & Acquisitions Tax Services practice, a dedicated team of experienced tax professionals who focus exclusively on transaction-related tax matters. Tracy has the capabilities to provide valuable transaction advice at all points along a transaction's timeline.
- Private equity
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