Major Changes to IRS Partnership Audit Procedures Requires Review of Fund Documents
November 23, 2015
On November 2, President Obama signed into law The Bipartisan Budget Act of 2015 (the “Act”). The Act makes significant changes to Internal Revenue Service (“IRS”) audit procedures applicable to partnerships, effective for taxable years beginning after December 31, 2017. As a result, fund managers will need to carefully examine their fund documents to ensure that the audit procedures in the new Act do not have an unintended effect on investors.
Very generally, the changes made by the Act include the following:
- Partnerships will be responsible for directly paying increased tax attributable to IRS audit adjustments.
- However, partnerships may make an election to pass-through any such adjustments to the historic partners of the partnership, in which case the audit adjustments will be directly assessed on the partners.
- Certain partnerships with 100 or fewer partners can elect out of the new rules altogether.
- The “Tax Matters Partner” concept has been replaced with a concept of a “partnership representative.”
Each of these changes is discussed in more detail below.
Partnership Level Audit Adjustments
Under current law, the IRS audits most partnerships under the so-called TEFRA rules. Under these rules, partnerships are audited at the partnership level and any adjustments are passed through to the persons who were partners in the relevant taxable year that is under audit (the “reviewed year”) regardless of when the audit concludes.
Under the Act, partnerships will still be audited at the partnership level but any adjustments to items of taxable income, gain, loss or deduction as a result of the audit will be assessed at the partnership level, rather than the partner level. The amount of any additional tax will be determined by the IRS based upon the highest tax rate applicable to individuals or corporations. According to the Act, appropriate adjustments will be made for lower tax rates applicable to long-term capital gain and qualified dividend income of individuals as well as for amounts properly allocable to tax-exempt partners. The exact mechanism for these adjustments will likely be the subject of regulatory guidance.
The partnership will be required to pay the additional tax due in the year in which the audit concludes (the “adjustment year”) notwithstanding that the partners of the partnership (or their percentage interests in the partnership) may be different in the adjustment year than in the reviewed year.
Therefore, under the Act, a partner in an adjustment year could economically bear a tax liability for an earlier reviewed year in which he or she was not a partner or in which his or her partnership percentage was lower than in the reviewed year.
Election Out of Partnership Level Adjustments
Notwithstanding the general rules, a partnership may elect (within 45 days after the completion of an audit) to have any underpayment of income tax arising from an audit assessed on the partners directly rather than on the partnership. If this election is made, any additional tax will be imposed on those persons who were partners of the partnership in the reviewed year rather than being borne economically by the persons who are partners in the adjustment year.
If a partnership makes this election, then the audit adjustments will be imposed on each partner rather than on the partnership itself. The adjustments will increase the partner’s tax for the adjustment year but will apparently be computed based upon how the partner’s tax for the reviewed year (and subsequent years) would have increased if the adjustments were taken into account in the reviewed year. The downside of making this election is that any interest that is imposed on the underpayment of tax attributable to adjustments of the partner for the reviewed year will be imposed at a rate that is two percentage points higher than the normal rate.
The net result of this election is a mechanism that appears to be similar to the current system of audit adjustments.
Election Out of New Procedures
A partnership with 100 or fewer partners (generally, each person who receives a Schedule K-1 is treated as a partner for these purposes) may elect out of the new audit procedures entirely, provided that each of its partners is either an individual, a C corporation, a foreign entity that would be treated as a C corporation if it were domestic, an S corporation or an estate of a deceased partner. Therefore, partnerships with partnerships (including LLCs treated as partnerships) as partners will not be able to make this election. This election is made on the partnership’s annual tax return and the partnership must notify each partner that it has made the election. This provision could be applicable to management companies but would be unlikely to be applicable to funds given the limitation on the types of permissible partners for a partnership making this election.
A partnership that makes this election (and its partners) will be subject to the general procedures regarding audits of individuals.
Changes to Tax Matters Partner Concept
Under current law, each partnership must appoint a “Tax Matters Partner” who is responsible for representing the partnership in an IRS audit and notifying the partners of the progress of any such audit. The Tax Matters Partner must be a partner of the partnership.
The Act replaces the concept of a Tax Matters Partner with a “partnership representative” who has the sole authority to act for the partnership on an audit. The partnership representative is designated by the partnership and need not be a partner but must have a “substantial presence in the United States.” At this time, it is unclear how a partnership designates a “partnership representative” and what it means to have a “substantial presence in the United States.” These items are expected to be the subject of future regulatory guidance.
Review of Existing Fund Documents
The Act represents a significant change in the treatment of partnerships for federal income tax purposes. From the perspective of a domestic investment fund, under current law, a new investor was unlikely to have liability for trailing tax liabilities of the fund because all audit adjustments were assessed based upon the examined year and passed through to the persons who were partners during that examined year. Most partnership agreements have been drafted based upon the assumption that the partnership itself is not a taxpayer as an entity but it merely passes through taxable items to its partners. The potential for partnership level tax adjustments is a major conceptual change and the limited partnership agreements and offering memoranda of domestic funds should be reviewed to ensure that they adequately address any potential issues arising from the changes contained in the Act.
In particular, private investment funds should review their documents for the following items prior to the Act’s effective date of January 1, 2018:
- The limited partnership agreement should give the general partner the authority (in its sole discretion) to elect partner-level audit adjustments;
- Given that an adjustment may be made to partnership items in the adjustment year with respect to a reviewed year in which different persons may have been partners, the partnership should have the ability to allocate any partnership level adjustments to persons who were partners during the reviewed year; and
- The offering memorandum of the fund may need to be updated to discuss the new audit regime.
An investor who is entering into a side letter with a manager may wish to request that the partnership in which it invests will elect the application of partner level adjustments (perhaps above a certain threshold).
A great deal about the actual implementation of the Act is unknown at this point. However, it is expected that IRS regulations will provide significant additional guidance. We will continue to monitor the implementation of the Act and keep you apprised of any further developments.
If you have any questions regarding the Act, 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) or Daniel C. Murphy (212-574-1210).