Sweeping changes to the rules governing federal income tax audits of partnerships went into effect this year. The new partnership audit rules (the “New Audit Rules”) apply for partnership tax returns for taxable years beginning on or after January 1, 2018. The historic partnership audit rules (the “TEFRA Rules”) continue to apply for partnership tax returns for taxable years beginning before 2018. The New Audit Rules were enacted to facilitate the IRS’ ability to collect taxes arising from partnership audits but impose substantial new burdens on partnerships and their partners. The New Audit Rules likely signal a significant increase in IRS partnership audit activity in years to come.
Contrary to the nature of partnerships as “flow through” entities, and to the approach taken under the TEFRA Rules, the partnership rather than its partners has primary liability under the New Audit Rules for any tax adjustment arising from an audit, including penalties and interest. In addition, the “Tax Matters Partner” or “TMP” role under the TEFRA Rules is replaced with the “Partnership Representative” or “PR,” who has substantially greater authority than the TMP. For purposes of this advisory, the term “partnership” refers to general partnerships, limited partnerships, limited liability partnerships, and limited liability companies (“LLCs”) classified as partnerships for federal income tax purposes and the term “partner” refers to any equity owner of any of these entity types.
Given the significant changes represented by the New Audit Rules and the need to designate a partnership’s PR on, and make elections with respect to, partnership tax returns for taxable years beginning on or after January 1, 2018, partnerships should consider amending their existing partnership or LLC Agreements to address these new rules.
Under the TEFRA Rules, all partnerships (other than partnerships that satisfied a small partnership exception) were required to appoint a TMP. Only a partner could serve as a TMP and, if the partnership had one or more general partners, the TMP was required to be one of the general partners. For LLCs, the TMP was required to be a member and, if there were one or more members who were also managers of the LLC, the TMP had to be a member-manager. Under the TEFRA Rules, the IRS generally provided notice to the partners of the commencement of an audit, the TMP was required to keep the partners reasonably informed of the status of an audit, and partners were permitted to participate in the audit proceedings.
The New Audit Rules replace the TMP with the PR. The PR is no longer required to be a partner, but must have a “substantial presence” in the United States under rules described in the Treasury Regulations. If the PR is an entity, an individual (who also meets the requirements to serve as a PR) must be appointed to act exclusively on behalf of the PR in its interactions with the IRS. The New Audit Rules give the PR exclusive authority to act on behalf of, and bind, the partnership in any federal tax audit or related judicial tax proceeding as well as to make (or choose not to make) any elections available under the New Audit Rules. Partners of a partnership under audit are no longer entitled to receive notice, or information regarding the status, of the audit nor are they permitted to participate in the audit or in other administrative or judicial partnership tax proceedings. Consequently, identifying the appropriate person to serve as the PR, and establishing appropriate contractual responsibilities and restrictions on the actions of the PR, take on much greater importance under the New Audit Rules.
Partnership Level Liability and “Push-Out Election”
Under the TEFRA Rules, all audit adjustments flowed through to the partners of the partnership for the taxable year(s) under audit and those partners were responsible for the resulting tax liability. In contrast, under the New Audit Rules, primary liability for any audit adjustment (including the tax deficiency and any related penalty and interest) is imposed on the partnership, unless the PR makes a timely election on behalf of the partnership to “push-out” that audit adjustment to the partners for the taxable year(s) under audit (the “Push-Out Election”). Consequently, absent a Push-Out Election (or an Opt-Out Election, discussed further below), the persons who are partners in the year in which the audit is resolved will bear the economic burden of the audit adjustments, even if they were not partners during the taxable year(s) under audit or if their interests in the partnership changed in the interim. A Push-Out Election comes with a cost, however: the interest rate imposed on any tax deficiency resulting from the audit is increased by 2 percent. If the PR does not timely make a Push-Out Election and the partnership fails to timely pay the audit adjustment, the IRS may assess the audit adjustment directly against the persons who are partners of the partnership in the year in which the audit is concluded. Recent legislation has confirmed the ability of partnerships to make the Push-Out Election sequentially up the chain of tiered-partnership structures.
Under the TEFRA Rules certain small partnerships (partnerships with 10 or fewer partners all of which were either individual U.S citizens or residents, C corporations, or estates of deceased partners) were automatically exempted from partnership-level audit proceedings, unless an affirmative election was made to have the partnership-level audit proceedings apply. Absent that election, the IRS audited the individual partners and not the partnership. Under the New Audit Rules, there is no longer an automatic exemption from the partnership-level audit rules. Instead, certain partnerships with 100 or fewer partners (all of which must be individuals, a deceased partner’s estate, a C corporation, an S corporation (whose shareholders count towards the 100-partner limit) or any foreign entity that would be treated as an C corporation if it were a domestic entity) may make an annual election to opt out of the partnership-level audit proceedings (the “Opt-Out Election”). The PR makes such an election on the partnership tax return for the taxable year in question. If the Opt-Out Election is made for a taxable year, the entity-level audit provisions of the New Audit Rules do not apply; instead, the audit is conducted at the partner level. As a practical matter, this election is of diminished utility because a partnership that has any partnership, trust (including a grantor or revocable living trust) or any disregarded entity as a partner may not make the Opt-Out Election.
Need to Amend Existing Partnership or LLC Agreements
We strongly encourage all of our clients to have their partnership or LLC agreements reviewed and revised to address the New Audit Rules, including:
- Identifying the PR or a mechanism for selecting the PR, as well as a process for replacing the PR. This is necessary even for partnerships that are eligible to make an Opt-Out Election, because the PR is the person who must make the election on an annual basis on the partnership’s tax return.
- Establishing the authority and responsibilities, and any contractual restrictions or fiduciary duties imposed on, the PR. Contractual restrictions might include requiring approval by the board or certain partners for material actions of the PR. While contractual restrictions are not binding on the IRS, they are enforceable as among the PR and the partnership and its partners and can serve as a means of controlling and moderating the exclusive authority the PR has to bind the partnership in audit and tax proceedings with the IRS.
- Establishing whether the PR is required to make available elections, including the Opt-Out Election and the Push-Out Election.
- Determining the extent to which the PR will be indemnified by the partnership. Along with the greater authority granted to PRs comes the increased likelihood that decisions of the PR will have disproportionately adverse consequences on certain current or former partners of the partnership, which could be a source of litigation against the PR. Consequently, any person considering serving as a PR will want to have appropriate indemnification provisions in place to limit his or her financial liability.
- For partnerships currently eligible to make the Opt-Out Election under the New Audit Rules, considering whether transfer restrictions should be imposed that would preclude transfers that would prevent the partnership from making the election.
In the process of amending a partnership or LLC agreement as a result of the New Audit Rules, consideration should also be given to whether the agreement should be updated to take into account any changes made to the partnership or LLC statute governing the entity since the agreement was entered into or last updated, or to reflect any intervening changes in the partnership’s ownership or other governance matters.