The president signed a budget bill into law on Nov. 2 that replaces the current partnership audit procedures with a new process that dramatically increases the payment and reporting responsibilities for partnerships.
The new rules are meant to make it easier for the IRS to audit partnerships and assess and collect tax after audits. The IRS has argued that examining large partnerships is difficult because adjustments must be made for each partner and sometimes through multiple tiers of partnerships. Audit statistics show that large C corporations are 33 times more likely than a similarly sized partnership to face an audit. The IRS and the administration have been proposing changes to the partnership audit rules for years.
Changes were finally enacted as part of the Bipartisan Budget Act of 2015 (P.L 114-74, H.R. 1314) and are estimated to raise $9.3 billion over 10 years. The legislation builds on a proposal in a tax reform discussion draft from former Ways and Means Committee Chair Dave Camp, R-Mich., and the Partnership Audit Simplification Act of 2015 (H.R. 2821) introduced earlier this year by Reps. Ron Kind, D-Wis., and Jim Renacci, R-Ohio. Congressional leadership, however, made significant departures from these proposals in the final enacted version, to address concerns raised by stakeholders.
Still, the new rules represent a profound shift not only for partnerships, but also for many C corporations, tax-exempt entities, S corporations and trusts that are partners in partnerships. The rules are designed to shift the burden for actually assessing tax after a partnership-level adjustment from the IRS to the partnership and partners. Partnerships will likely need to consider changes to their partnership and operating agreements to respond to the new rules, and individuals or entities entering into partnerships should understand how the new rules could affect their future liability.
The legislation repeals the partnership audit procedures under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) and the audit procedures for Electing Large Partnerships (ELP) and replaces them with a single regime for auditing, making adjustments and collecting assessments at the partnership level.
Like TEFRA, the new audit procedures create an exception for certain smaller partnerships. Partnerships with 100 or fewer partners (defined as partnerships required to issue 100 or fewer K-1 statements) can opt out of the new audit procedures annually only if their partners are limited to individuals, C corporations (including foreign entities that would be considered C corporations if domestic), S corporations and estates of deceased partners. Partnerships with other types of partners, such as partnerships, trusts, or certain tax-exempt entities, could not opt out of the new audit procedures, much like under TEFRA.
Real estate investment trusts and regulated investment companies are not excluded as permissible C corporation partners, as in prior versions of the proposal. If an S corporation is a partner, each shareholder of the S corporation counts toward the 100-partner threshold. Partnerships with 100 or fewer permissible partners who opt out will now be subject to the individual audit procedures that currently apply only to partnerships with 10 or fewer partners. These rules require separate audits of each partner.
The bill requires partnerships to designate a representative with a role similar to a tax matters partner under TEFRA. The representative can be any partner (or other person) with a substantial presence in the United States. If a partnership does not designate a representative, the IRS is free to designate anyone it chooses. The representative has the sole authority to act on behalf of the partnership in exam, and the decisions made by the representative are binding.
Other partners retain no rights in administrative proceedings and are unable to challenge IRS determinations separately, but can still file inconsistently with the partnership return with notification to the IRS. A partner can also file inconsistently when receiving incorrect information, so long as the partner can demonstrate consistent treatment of the item to the IRS. Otherwise, any underpayment due to inconsistent treatment is assessed in the same manner as a mathematical or clerical error.
Math or clerical error treatment of inconsistent filings by a partner is an important change from TEFRA. Section 6213(a) allows a taxpayer to petition the Tax Court within a certain number of days of receiving a notice of deficiency. However, adjustments related to math errors are considered outside of deficiency proceedings, and taxpayers are unable to petition the Tax Court. While taxpayers can usually challenge math error adjustments within 60 days under Section 6213(b)(2), the new legislation specifically prohibits such challenges, unless a partner notifies the IRS of the inconsistent treatment.
Procedures for assessment and payment
The legislation creates two options for paying tax after a partnership assessment. The general rule uses procedures similar to the ELP rules, in which the partnership itself is responsible for paying the tax. The alternative procedure is more like TEFRA, in which adjustments are passed through to partners -- except that the partnership, not the IRS, is be responsible for issuing adjustments.
Partners are not jointly and severally liable for all partnership underpayments, a significant improvement from earlier drafts. Previous versions of the legislation would have made all partners, both in the year under review and the year in which the adjustment is made, jointly and severally liable for a partnership’s full underpayment amount.
Default procedures for assessment and payment
Absent an election into the alternative method, a partnership is generally required to calculate its additional tax by netting all adjustments of items of income, gain, loss or deduction, and multiplying the net amount by the highest individual or corporate tax rate in effect for the reviewed year. The legislation calls this the “imputed underpayment,” and the statute explicitly provides only four ways to reduce this amount:
- Tax-exempt partners – The imputed underpayment may be reduced to the extent the adjustment is allocable to tax-exempt partners.
C corporation partners – The partnership may reduce the imputed underpayment by applying the top corporate rate of 35% to an amount of ordinary income items allocable to C corporation partners.
Individual capital gains and dividends – The partnership may reduce the imputed underpayment by applying the top rate of 20% on capital gains and dividend income allocable to individuals.
Partner amended returns – The imputed underpayment may be reduced to the extent partners amend their returns for the tax year, including the end of the reviewed partnership year, to reflect their allocable share of the adjustment. In the case of an adjustment that reallocates the distributive share of any item among partners, the amended return feature reduces the imputed underpayment amount only if all the affected partners amend their returns to reflect the adjustment.
The legislation does not explicitly allow a partnership to reduce the imputed underpayment by any share of ordinary income that would be taxed at lower income tax rates based on a partner’s tax bracket, or for capital gain items of a C corporation. However, the statutory language grants the IRS broad authority to provide additional procedures to modify the imputed underpayment “on the basis of such other factors as the Secretary determines are necessary or appropriate to carry out the purposes of this subsection.”
Alternative partner assessment procedure
As an alternative to the default assessment procedure, the partnership has the option of passing the adjustment to partners for the reviewed year by making an election and issuing a “statement” to each partner within 45 days of the adjustment, to reflect each partner’s share of changes to income, gain, loss, deduction or credit. The legislation leaves many of the details of this alternative payment option up to the IRS.
Each partner is required to pay any additional tax due as a result of the adjustment in the year the partner receives the statement from the partnership. Penalties are determined at the partnership level, and each partner is liable for the additional amount. Interest is assessed at the partner level from the due date of the return for the tax year to which the increase can be attributed.
The legislation does not specify how a partner that is another partnership would handle the adjustment, such as whether it would pay the tax itself under the new general rule, pass along the adjustment to its partners under the alternative approach or choose either.
Implications of the two options for adjustments
The decision of whether to pay the imputed underpayment at the partnership level or pass the adjustment on to partners has many important implications. Under the general rule, paying tax at the partnership level places the economic burden on the entities and individuals who are current partners in the year the audit is completed, unless the partnership agreement provides otherwise.
This will particularly affect new partners who were not in the partnership in the year reviewed, and partners such as tax-exempt entities, which would pay less or no tax if the adjustment was passed to them. Even though the imputed underpayment can be reduced by amounts allocable to tax-exempt and other partners, the remaining nondeductible expense at the entity level could still harm these partners’ economic interests absent a mechanism in the partnership or operating agreement that compensates them.
The election to pass the adjustment to partners shifts the economic burden back to those individuals and entities that were actually partners in the year under review, though they would take the adjustment into account in the year they received a statement from the partnership. The election will also affect the aggregate amount paid to the IRS. When paying the imputed underpayment at the entity level, the partnership can make no adjustments for a C corporation or individual partner who would pay tax at a rate lower than the top bracket, and partners lose the ability to use any adjustment that would create passive income to offset passive losses. On the other hand, paying at the entity level may avoid self-employment tax or tax on net investment income, as discussed earlier. Paying at the entity level also avoids a two-percentage-point increase in the interest rate that applies to partners when the adjustment is passed on to them.
The legislation modifies the procedures for how a partnership can make an administrative adjustment request (AAR). If the AAR resulted in an underpayment, the partnership can choose to either use the method for paying tax itself under the general rule, or the alternative approach of issuing statements and passing the adjustments to partners. Under the alternative approach, partners must amend their returns and pay additional tax as a result of the adjustment. This is different from the approach taken when the adjustment results from an audit, which requires partners to take the adjustment into account in the year they receive the statement. If the AAR does not result in an underpayment, the partnership uses the alternative procedure to issue statements, and the partners amend their returns for a potential refund.
Under current practice, the IRS typically does not adjust the returns of partners for refunds after a partnership adjustment in the same way it would adjust their returns in the case of an underpayment. Instead, the IRS has required partners who are due a refund through an amended Schedule K-1 to proactively submit a claim for refund through an amended tax return. The legislation appears to turn that informal practice by the IRS into law. However, this is yet another issue that requires interpretation and guidance by the IRS and Treasury.
A partnership can file an AAR within three years after the later of the date the partnership filed its return or the last day for filing the partnership return for such tax year (determined without regard to extensions).
The legislation is generally effective for partnership tax years beginning after Dec. 31, 2017, although partnerships can elect to apply the new rules for any return filed for tax years beginning after Nov. 2, 2015, if the IRS provides procedural rules to do so. The delay gives partnerships time to prepare, but the effective date actually comes more than a year sooner than earlier versions of the legislation had proposed.
Considering the breadth of guidance the IRS will need to issue and the IRS’s discretion the in deciding how the elections and underpayment calculations will operate, partnerships may have to act quickly to respond once rules are effective. Partnerships, both existing and new, should begin evaluating their partnership and operating agreements and considering if changes will be needed to address a variety of issues, including:
Whether to agree in advance about which option the partnership will select for paying tax after an adjustment
How to assign the economic burden of paying any imputed underpayment at the entity level
Whether to bar the entry of future partners who could prevent the partnership from opting out of the new regime and into the small partnership rules
Who the designated representative will be and how future designated representatives will be selected
Any individual or entity entering into partnership should also review existing agreements closely for the implications under the new rules. Under the general adjustment procedures, the economic interests of new partners can be exposed to liability for tax positions taken before they entered the partnership, and new partners may wish to consider requesting mechanisms, such as indemnities, to reduce exposure. Partners also have fewer rights in administrative proceedings than under TEFRA, so the partnership’s choice of a designated representative is even more important.
Tax professional standards statement
This content supports Grant Thornton LLP’s marketing of professional services and is not written tax advice directed at the particular facts and circumstances of any person. If you are interested in the topics presented herein, we encourage you to contact us or an independent tax professional to discuss their potential application to your particular situation. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed herein. To the extent this content may be considered to contain written tax advice, any written advice contained in, forwarded with or attached to this content is not intended by Grant Thornton LLP to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.
The information contained herein is general in nature and is based on authorities that are subject to change. It is not, and should not be construed as, accounting, legal or tax advice provided by Grant Thornton LLP to the reader. This material may not be applicable to, or suitable for, the reader’s specific circumstances or needs and may require consideration of tax and nontax factors not described herein. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Changes in tax laws or other factors could affect, on a prospective or retroactive basis, the information contained herein; Grant Thornton LLP assumes no obligation to inform the reader of any such changes. All references to “Section,” “Sec.,” or “§” refer to the Internal Revenue Code of 1986, as amended.