Partnership Audit Changes and Their Effect on Operating Agreements
On November 2, 2015, President Obama signed into law the Bipartisan Budget Act of 2015. The Bipartisan Budget Act of 2015 contained several significant changes to the procedural rules for federal income tax audits and the judicial process that are applicable to partnerships and other entities that are classified as partnerships for federal income tax purposes, like limited liability companies. These changes are a departure from how partnerships have been treated for federal income tax purposes. In the past, partnerships were treated as a flow through entity and not subject to federal income tax. The Bipartisan Budget Act of 2015 repealed the current federal audit procedures for partnerships enacted by the Tax Equity and Fiscal Responsibility Act of 1982. The Bipartisan Budget Act of 2015 replaced the federal audit procedures for partnerships with the following rules. These new audit procedural rules will have a profound impact on existing and new partnerships.
The federal income tax audit or judicial proceedings will continue to be conducted at the partnership level, but the first major change is that a tax liability, including penalties and interest, from a federal income tax audit or judicial proceeding will be imposed directly on the partnership and not on the partners individually. Adjustments to the partnership’s income, gain, loss, deduction or credit for a particular year (called the “review year”) are taken into account by the partnership in the year that the federal income tax audit or judicial proceeding is completed (called the “adjustment year”). This change shifts the ultimate tax consequences from the partners of the partnership in the review year to the partners of the partnership in the adjustment year. The shift creates tax risk when acquiring interests in existing partnerships. For new partnerships, this tax shift must be considered so that the economic arrangement of the partners is properly reflected in the partnership agreement or in the LLC operating agreement.
The calculation of the tax imposed on the partnership in the adjustment year is done by taking all of the adjustments to the partnership’s income, gain, loss, deduction or credit for review year and netting them all together. This net amount of adjustment is then multiplied by the either the highest individual or corporate tax rate that was in effect in the review year. This amount is called the imputed underpayment and is imposed on the partnership in the adjustment year. Adjustments to the allocation between partners will not be netted, but instead will be taken into account only to increase allocations of income or decrease the allocations of deductions to the particular partner. For example, there can be a situation where the partnership has an imputed underpayment owed because of an incorrect allocation of items of income or deduction among partners.
Modifications to the Imputed Underpayment
The imputed underpayment may be reduced by (1) the partners filing amended tax returns and paying the related tax payment for the review year, (2) the correct tax rate applicable to specific partners (like tax-exempt entities), or (3) the type of income subject to the adjustment (like capital gains). After the proposed partnership adjustment is mailed, the partnership has 270 days to submit the necessary information and documentation to the Internal Revenue Service (IRS) for modification of the imputed underpayment. The IRS must approve all modifications to the imputed underpayment of a partnership.
The amended tax return modification requires that one or more partners file returns for the taxable year of the partner which includes the end of the reviewed year of the partnership, the amended returns take into account all adjustments properly allocable to such partners (and for any other taxable year with respect to which any tax attribute is affected by reason of such adjustments), and a payment of any tax due is included with the amended returns.
As an alternative to imposing the imputed underpayment to the partnership, the partnership can elect, within 45 days of receiving an IRS final notice of partnership adjustment, to issue statements to the partners who were partners in the review year, their share of any adjustment to the partnership’s income, gain, loss, deduction, or credit. The partners receiving these statements will be required to take the adjustments into account on their individual tax return in the year in which the adjustment statements are issued. The reviewed year partner’s tax for the adjustment year is increased by the sum of the increases in that partner’s tax for the reviewed year and subsequent affected years that would be generated if the adjustments were taken into account by such partner for those years. In addition, those partners will owe interest and penalties, if applicable, but the interest will be two percent higher than is normally applicable to tax underpayments.
Administrative Adjustment Request
A partnership also has the option to file a request for an administrative adjustment for the review year when the partnership’s position is that an additional payment is due or an overpayment was made. The adjustment will be taken into account in the adjustment year at the partnership level. The partnership can also use the alternative method for an administrative adjustment by issuing adjustment statements to each of the partners that were partners in the review year.
Both the alternative method of imposing the imputed underpayment and the request for an administrative adjustment should be considered when drafting the partnership agreement in order to properly convey the procedure agreed upon by the partners in a federal income tax audit or judicial procedures.
Another major change in the partnership audit rules is that the “tax matter partner” designation for federal income tax audits or judicial proceedings was repealed and replaced by the “partnership representative.” Each partnership needs to designate a partnership representative who is a person, not necessarily a partner, with a substantial presence in the United States. If the partnership has not designated a partnership representative, the IRS will select one. The partnership representative is the only person that will receive notice of any administrative proceeding that has been initiated, notice of any proposed partnership adjustment, and notice of any final partnership adjustment. The partnership representative has the sole authority to act on behalf of the partnership during a federal income tax audit or judicial proceeding.
The partnership representative’s decisions have a binding effect on the partnership and all of its partners in a federal income tax audit or judicial proceeding. Given the broad power of the partnership representative, it will be important to consider expressing the obligations of the partnership representative in the partnership agreement, for example, providing notice to the other partners about any notice of proceedings or requiring the partnership representative’s actions to be subject to a majority vote of the partners. Another consideration, if the partnership representative is a partner in the adjustment year and the partnership elects to use the alternative method of imposing the imputed underpayment, as described above, then it appears that the review year partners will not have the ability to have any judicial review of the resulting partnership adjustment.
Small Partnership Exception
As before in the prior partnership audit procedure regime, there is an exception for small partnerships to elect out of these new partnership audit procedure rules. During each tax year, if the partnership has 100 or fewer partners and all of the partners are either; individuals, a C corporation, any foreign entity that would be treated as a C corporation if it was domestic, a S corporation, or an estate of a deceased partner, then the partnership may elect this exception on its partnership tax return. Currently, a partnership that has a partnership or a single member limited liability company as a partner is not eligible for the small partnership exception. So in a tiered partnership structure, the lower tiered partnership will be subject to the new partnership audit procedures. In addition, if one of the partners is an S corporation, then the partnership must also provide a list of the S corporation shareholders’ names and tax identification numbers to elect this exception. The number of S corporation shareholders will also count towards the 100 partner limit for the exception. The IRS is currently drafting guidance on other rules for partners not described in the statute. This exception should also be considered in the partnership agreement as to whether or not the partnership is required to elect out of the general partnership audit procedures for a tax year, if the partnership meets all of the requirements.
These new partnership audit procedure rules are effective for partnership taxable years beginning after December 31, 2017. A partnership may elect to apply these new rules, but not the small partnership exception, for taxable years beginning after November 2, 2015, and before January 1, 2018.
Currently, the IRS is still in the process of issuing guidance in this area. Given the radical change in the new partnership audit procedure rules detailed above, it is important to review existing and new partnership/LLC agreements to make sure that the agreements are in line with the intent of the partners. These new rules must also be considered if a new partner intends to join a partnership.