To the surprise of many practitioners and taxpayers, substantial changes have been made to the way partnerships will be audited by the Internal Revenue Service. These changes go into effect for returns filed for taxable years beginning after December 31, 2017. The Bipartisan Budget Act of 2015 repeals existing procedural rules, including those under TEFRA, and introduces a regime in which partnerships may, as an entity, be subject to additional tax, interest and penalties.
Many of the operational details of these new rules have been delegated to the Treasury Department. Proposed regulations, which were initially released in January 2017 and withdrawn as part of a regulatory freeze by the Trump administration, have been re-released in substantially identical form on June 14, 2017. While the proposed regulations are not yet final or effective, partnerships must understand the guidance in order to be prepared to address future final regulations.
Partnerships will need to analyze and evaluate a number of issues when evaluating the new audit rules. Some key considerations include:
- Whether the partnership is eligible to elect out of the new rules and, if so, whether such an election is advisable.
- If a push-out election should be considered when a partnership cannot elect out of the new rules and, if so, whether the partnership will be able to provide the necessary partner statements.
- Whether a partnership that has not opted out may calculate imputed underpayment modifications to reduce any potential exposure and, if so, beginning the information gathering process.
- Whether the partnership must amend its operating agreement to take into account the new partnership audit rules.
Partnership Agreement Considerations
The new partnership audit rules will require partnerships to take certain measures to come into compliance, some of which may be addressed in the partnership agreement:
- Designating a Partnership Representative. The proposed regulations require a partnership to designate a Partnership Representative (“PR”) for tax years beginning after 2017 (or if the new regime is elected earlier, at that time). Similar to the Tax Matters Partner (“TMP”) under the TEFRA rules, a PR is the point of contact between the entity and the IRS. Also like the TMP, a PR may bind the partnership. Unlike the TMP, however, a PR may bind all partners to the conclusions of an audit proceeding. Moreover, unlike a TMP, a PR may be a non-partner, as long as the PR has a substantial U.S. presence. If a partnership fails to designate a PR, the IRS may do so on its own initiative. Therefore, a partnership should designate a PR or, at a minimum, determine the procedures for designation.
- Preparing for an Opt-Out Election. For those eligible partnerships that prefer to opt out of the new audit rules, an election must be made annually with the filing of the partnership tax return. In this case, the partnership may consider specifying in the partnership agreement its intent to make the election. In drafting such a provision, the partnership must consider the impact of S corporation partners and the need to secure their agreement. Moreover, any agreement may be set up to avoid ownership by those which would make the partnership ineligible to opt out, such as other partnerships, trusts, disregarded entities and nominees. Partnerships currently ineligible to opt out because of their structure may want to consider whether they should restructure their ownership or not.
There are two conditions that must be met for a partnership to be eligible to elect out of the centralized partnership audit regime. First, a partnership must have 100 or fewer partners during the year. This requirement is met only if the partnership is required to furnish 100 or fewer Schedules K-1 to partners for the year regardless of how many Schedules K-1 are actually issued. For example, if a partnership furnishes two separate Schedules K-1 to a partner holding both a general and limited partnership interest, the partnership is treated as having furnished a single Schedule K-1 to that partner because only one Schedule K-1 is required. If a husband and wife each own an interest in the same partnership, however, they are treated as two partners for purposes of this rule, as they are both required to receive a separate Schedule K-1 The proposed regulations include a special rule for partnerships that have S corporation partners: Any Schedules K-1 required by the S corporation to its shareholders for the taxable year of the S corporation, ending with or within the partnership’s taxable year, are taken into account in determining whether the partnership is required to furnish 100 or fewer Schedules K-1 for that taxable year.
The second requirement for eligibility is that at all times during the year all the partners must be eligible partners. Eligible partners refer only to individuals, C corporations, eligible foreign entities, S corporations and estates of deceased partners. For this purpose, C corporations include regulated investment companies, real estate investment trusts, and tax exempt corporations (but not tax exempt trusts). Eligible foreign entities include foreign entities that are classified as corporations under Treas. Reg. sections 301.7701-2 and 301-7701-3, whether because they are per se corporations, have defaulted to corporate status, or have elected to be classified as a corporation. Notably, a disregarded entity is not an eligible partner, nor is a nominee or other person holding an interest on behalf of another.
- Preparing for a Push-Out Election. Partnerships that either cannot or prefer not to opt out may elect to push adjustments out to its reviewed-year partners. In such a case, it may be advisable for the partnership agreement to specify that intent and direct the PR to make a push-out election. NOTE: A partner entering or exiting a partnership should consider the tax implications of any existing and future tax liability resulting from the partnership’s election to push out any imputed underpayment.
The election must be made within 45 days of the date the final partnership adjustment (FPA) was mailed by the IRS. The time for filing the election may not be extended. The election must be signed by the PR and must include the name, address and correct taxpayer identification number (“TIN”) of the partnership; the taxable year to which the election relates; the imputed underpayment(s) to which the election applies (if there is more than one imputed underpayment in the FPA); each reviewed year partner’s name, address and correct TIN and any other information required by forms, instructions and other guidance. All reviewed year partners are bound by the election, meaning each reviewed year partner must take the adjustments on the statement into account and report and pay additional tax, penalties and interest.
A partnership making the push-out election must furnish statements to the reviewed year partners with respect to the partner’s share of the adjustments and file those statements with the IRS. The statements must be filed and furnished separate from any other statements required to be filed with the IRS, and furnished to the partners for the taxable year, including any Schedules K-1. Therefore, the partnership may not include the partnership adjustments that are to be taken into account by the reviewed year partners on any Schedule K-1 required to be furnished to the partner for the year. Similarly, the partnership must furnish separate statements for each reviewed year at issue, and cannot combine multiple reviewed years (if any) into a single statement. The statements must be provided to the reviewed year partners no later than 60 days after the date the final partnership adjustments are determined.
- Preparing to Modify the Imputed Underpayment. A partnership that makes neither an opt-out nor push-out election may want to modify any imputed underpayment amount as permitted under the proposed regulations. In such case, it may be desirable to specify in the partnership agreement that impacted partners will provide any necessary documentation or file amended returns as needed.
Despite the considerable scope of the proposed regulations, there remain a number of issues that will need to be addressed in future guidance before the new audit rules become effective.
Perhaps the most significant issue yet to be addressed is how adjustments under the new rules will affect the basis and capital accounts of the adjustment year partners, as well as the partnership’s tax and section 704(b) “book” basis in its assets. The Treasury has determined that generally, the adjustment year partners’ outside basis and capital accounts, and a partnership’s basis in its property, should be adjusted to what they would have been if the adjustments were made in the reviewed year; these amountsshould then be modified to take into account how the adjustments would have effected taxes in intervening years. However, the IRS has not yet determined how to draft mechanical rules achieving appropriate results and has requested public comments on the matter.
The IRS is also considering whether a pass-through partner who receives a push-out statement should be allowed to push that adjustment out to its own members. A technical corrections bill introduced in Congress in December 2016 would resolve the question and provide that a partner that is a partnership or S corporation may elect to either pay an imputed underpayment, or flow the adjustments through the tiers. The IRS also has requested public comment on how to administer the push-out rules in tiered structures.
Finally, The IRS is deciding on how to coordinate the push-out rules with withholding requirements for foreign and certain domestic partners; how to treat partners that are estates, trusts or foreign entities (such as controlled foreign corporations) that might not be directly subject to tax on adjustments but whose owners may be and how to treat adjustments to creditable foreign tax expenditures, and other adjustments affecting the amount of foreign tax credit that might be allowable to partners.