The Internal Revenue Service (“IRS”) recently finalized regulations and amended Form 1065 (U.S. Return of Partnership Income) as part of its efforts to implement the centralized partnership audit regime. The centralized partnership audit rules were enacted in 2015 and apply to returns for tax years beginning after December 31, 2017 (unless a partnership had elected to apply these rules to an earlier tax year).
The final regulations and amended Form 1065 come in advance of the due dates for filing the first partnership tax returns to which the new audit rules apply. This Memorandum highlights some key features of the new centralized partnership audit regime.
I. Audits Conducted at Partnership Level.
An IRS audit of a partnership under the new regime will occur solely at the partnership level. Partners are not permitted to participate in these proceedings. In addition, partners are bound by the actions of the partnership representative (see section II below). In the event of an adjustment, any tax liability will generally be paid by the partnership (unless an election is made to push the tax liability out to the partners) (see section III below). Certain small partnerships may elect out of these rules.
II. Partnership Representative replaces the Tax Matters Partner.
The partnership representative is the designee that will represent the partnership in an IRS audit. The partnership representative has broad authority to bind the partnership and the partners in an audit. The partnership representative can be any person with a substantial presence in the United States (that is a U.S. tax identification number, a U.S. address and phone number and the ability to meet with the IRS during normal business hours). Where an entity is designated as the partnership representative, an individual with a substantial presence in the United States must also be designated on the partnership’s tax return as the sole individual through whom the partnership will act in the connection with the IRS audit.
Funds should consider appointing the general partner or the investment management company as the partnership representative and a senior officer responsible for tax matters as the designated individual.
III. Pushing a Tax Liability Out to Partners.
Generally, tax liabilities resulting from an IRS audit are paid by the partnership at the highest marginal tax rate applicable to the partners. This could be problematic for partners because partners in the year when the audit is finalized (the “adjustment year”) may not have been partners (or may have different percentage interests) in the partnership for the year that is the subject of the audit (the “reviewed year”). In addition, certain partners may be tax-exempt or in a lower tax bracket. In these cases, partners in the adjustment year may bear the economic burden of the tax liability resulting from the audit if the partnership pays the tax.
The audit rules permit the partnership representative to push out the tax liability to the partners. Generally, the partnership representative may elect to push out the tax liability within 45 days of the IRS mailing the notice of final partnership adjustment. Making this election requires the partners of the partnership during the reviewed year to pay their respective shares of the tax liability, taking into account their individual facts and circumstances. This election is available to tiered partnerships, such as master funds.
IV. Applying Modification Procedures to Reduce the Tax Paid by a Partnership.
Although the partnership is required to pay any tax liability resulting from an audit at the highest marginal tax rate of the partnership, the partnership representative may request to modify the imputed underpayment of tax by taking various factors into account. Modifications can be requested if certain partners are tax-exempt, foreign, in a lower-tax bracket, or a qualified investment entity (i.e., a RIC or a REIT).
V. Updated IRS Form 1065.
The IRS also updated Form 1065 to account for the new partnership audit rules.1 In particular, new lines were added to allow for designating the partnership representative and electing out of the new partnership audit rules.
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For additional information on the partnership audit rules, please contact please contact Ronald P. Cima (212-574-1471), Jonathan P. Brose (212-574-1615), James C. Cofer (212-574-1688), Peter E. Pront (212-574-1221), Daniel C. Murphy (212-574-1210), or Brett R. Cotler (212-574-1269).
Links to our prior Memoranda on the new partnership audit regime:
- IRS Finalizes Partnership Representative Regulations (August 15, 2018).
- IRS Proposes to Permit Push-Out Election for Feeder Funds (December 18, 2017).
- Major Changes to IRS Partnership Audit Procedures Requires Review of Fund Documents (November 23, 2015).
1 Form 1065 was also updated to include questions related to recent tax reform related changes. Namely, there are new questions relating to the current business interest deductibility rules. There is also a line item for partnerships that are self-certifying as Qualified Opportunity Funds.