Under the currently applicable TEFRA unified partnership audit rules, partnership item tax treatment (and the applicability of any penalty, addition to tax, or additional amount that relates to an adjustment to a partnership item) is generally determined at the partnership level, and flow through to the partners for the year in which the adjustment takes effect.
TEFRA audit rules don’t apply to partnerships having 10 or fewer partners, each of whom is an individual (other than a nonresident alien), a C corporation, or an estate of a deceased partner, unless the partnership elects to have the TEFRA rules apply.
Simplified audit procedures apply to large partnerships with 100 or more partners that elect to be treated as electing large partnerships for reporting and audit purposes.
The Bipartisan Budget Act of 2015 (the Act)
The Act repealed the TEFRA uniform partnership audit rules and replaced them with a streamlined single set of rules for auditing partnerships and their partners at the partnership level.
The statute raises a number of questions, some of which might be considered for a technical corrections bill.
In general, adjustments to partnership income, gain, loss, deduction, or credit are determined at the partnership level, and any tax attributable to such adjustment is assessed and collected, and the applicability of any penalty, addition to tax, or additional amount which relates to an adjustment to any such item or share is determined, at the partnership level.
“Tax” resulting from a partnership’s audit’s increase in taxable income is levied on the partnership, not partners. Income, gain, loss, and deduction adjustments items are aggregated, the aggregate is modified in certain ways, and the modified aggregate is multiplied by the highest individual or corporation tax rate (not the highest rate applicable to a partner), and increased (or decreased) by each credit adjustment. The partnership owes the imputed underpayment plus penalties, if applicable, and apparently interest.
For most partnerships the new regimen applies to partnership returns for tax years beginning after Dec. 31, 2017. Smaller partnerships can elect-out, and partnerships can also elect for the changes to apply to any return of the partnership filed for partnership tax years beginning after Nov. 2, 2015 (the Act’s date of enactment) and before Jan. 1, 2018.
The schedule of the basic steps that will occur in a proceeding under the new regimen initiated by the IRS are:
- Initiation of the process.
- Issuance by the IRS of a notice of proposed partnership adjustment.
- Deadline for application by the partnership/partners of the amended return mechanism (including submission of supporting materials) 270 days after the notice of proposed partnership adjustment.
- Issuance by the IRS of a notice of final partnership adjustment no earlier than 270 days after the notice of proposed partnership adjustment.
- Deadline for a passthrough election by the partnership 45 days after the notice of final partnership adjustment.
- Deadline for filing suit by the partnership 90 days after the notice of final partnership adjustment.
The partnership can wait to make a final decision on whether or not to make a passthrough election until after the notice of final partnership adjustment, which cannot be filed before the deadline for achieving the amended return mechanism. In other words, one need not irrevocably decide either way on the passthrough election before one has good knowledge of what the partners and former partners have done with respect to the amended return mechanism.
Small Partnerships Can Elect-Out
- the partnership provides 100 or fewer Schedule K–1s:
- each partners is an individual, a C corporation, a foreign entity that would be treated as a C corporation were it domestic, an S corporation, or an estate of a deceased partner;
- the election is made with the partnership’s timely filed return for the tax year and discloses the name and taxpayer identification number (TIN) of each partner of the partnership.
- the partnership notifies its partners of the election.
If a partner is an S corporation, the partnership will be treated as meeting the Code Sec. 6221(b)(1)(C) requirement with respect to the S corporation partner only if: (1) the partnership includes a disclosure of the name and TIN of each person with respect to whom the S corporation must furnish a Schedule K–1) for the tax year of the S corporation ending with or within the partnership tax year for which the election out is made; (2) the S corporation Schedule K–1s are treated as statements furnished by the partnership for purposes of Code Sec. 6221(b)(1)(B) 100-or-fewer statement rule.
The Tax is Shifted from the Year being Audited to the Audit Year
The economic burden of adjustments in the year being audited (“reviewed year”), is determined and applied in audit year (“adjustment year”), and is borne by the partners in the adjustment year in proportion to their interests in that year, and not by the partners in year being audited in proportion to their interests in the reviewed year.
Although its basic rule assigns responsibility for tax (via the imputed partnership underpayment resulting from audit year adjustments (and interest and penalties), the new regimen provides a couple of ways (in addition to the complete election out afforded by Section 6221(b)) to assign the responsibility in whole or in part, to the reviewed year partners.
Even if the the partners and their proportionate interest are substantially identical for the two years, the partnership’s tax would almost certainly differ from the additional tax payable by partners collectively if the adjustments were applied at the partner level because:
- the partnership tax rate is the maximum individual or corporation rate (rather than the potentially lower actual partner rate),
- the partnership applicable rate is determined by reference only to Sections 1 and 11 & does not include:
- self-employment income or
- the tax on net investment income,
- phase-out of itemized deductions
The rules penalize adjustments of distributive shares of items, at least in certain situations. The theoretical result of the general rule (partnership responsibility) would be that such an adjustment would have no effect on the amount of the partnership’s liability, because the increase and decrease would offset each other. But taxpayer-adverse adjustments are to be taken into account, and taxpayer-favorable adjustments are not to be taken into account.
A partnership can elect to pass the adjustments through to the partners in the reviewed year, thereby avoiding payment by the partnership. The partnership owes nothing.
But, each reviewed year partner’s (or former partner’s) tax for the adjustment year is increased by the sum of the increases in that partner’s (or former 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 (or former partner) for those years. In addition, those partners (and former partners) would owe interest from each reviewed year due date to the payment date (at 200 basis points higher than the normal interest rate applicable to tax underpayments), and penalties, if applicable.
The passthrough election mechanism is not by its terms an adjustment to anyone’s taxable income and tax for previous years. Rather, it is a (potential) increase in tax for the adjustment year (and nothing is said about a potential decrease in tax for any year, not even the adjustment year).
Nothing is said about what happens to a partner whose aggregate of adjustments is a decrease in net income, and if a partner is entitled to a refund (and interest), but the answer appears to be “No,” certainly if the earlier year is closed by the statute of limitations, but probably also for open years.
Amended Return Mechanism
Section 6225(c)(2) calls for an “amended return mechanism” to produce an adjustment if one (or more) reviewed year partners files an amended return for the reviewed year that takes into account “all adjustments … properly allocable to him, her or it (and for any other taxable year with respect to which any tax attribute is affected by reason of such adjustments”) and pays any (additional) tax due as a result of his, her or its shares of those adjustments. The result for the partnership is that the shares of adjustments so taken into account (and taxed) are disregarded in calculating the amount of the partnership’s imputed underpayment. Theoretically, this means that if all reviewed year partners file proper amended returns and pay the resulting additional tax (if any), there would be no resulting imputed underpayment for the partnership to pay.
The amended return mechanism is severely marred by anomalies sufficiently significant to render the mechanism impractical.
Although the amended return mechanism can apparently eliminate a partnership’s imputed underpayment, it is not clear that the partnership’s liability for interest and penalties (if applicable) would be eliminated.
What if the reviewed year (or some other affected year) is closed by the statute of limitations ? Can a reviewed year partner nevertheless file a return, and, if applicable, pay tax, for that year ? Contrarily, can a reviewed year partner whose share of the adjustments decreases net income file a return and claim a refund for a closed year ? There is some doubt of the applicability of the amended return mechanism to closed years because the required return filings and tax payments cannot actually be made.
There is a mismatch between the period used to determine a partnership’s imputed underpayment and the period applicable in connection with the amended return mechanism. A partner or former partner must file an amended return for the reviewed year that takes into account all adjustments properly allocable to him, her, or it and for any other tax year with respect to which any tax attribute is affected by reason of such adjustments to eliminate a partner’s or former partner’s adjustments from the calculation of the partnership’s imputed underpayment. The partners are to pay corrective tax for all affected years, but the “adjustments” to be taken into account in determining the partnership’s imputed underpayment are all for the reviewed year only, no other “affected” years are involved in that determination.
If the partnership does not owe tax because the aggregate of the adjustments decreases net income or leaves it unchanged, the aggregate is to be taken into account by the partnership either as a decrease in income or an increase in loss benefiting partners in the adjustment year (as a required payment under the basic rule would burden those partners). But there appears to be a difference between aggregates that increase net income and those that decrease net income, so that if the partnership is required to make a payment, interest apparently runs from the reviewed year (or subsequent affected year) to the date of payment, while if the aggregate decreases net income there appears to be no provision for interest.
The partnership apparently disregards the income-reducing adjustments (which would help the partnership) of partners whose shares of the adjustments decrease net income in the partnership’ in its own’s calculation. Those partners apparently can obtain refunds for any relevant year that is not closed by the statute of limitations, and it appears, but is not certain, that a partner with decreased net income can obtain a refund if a relevant year is closed.
Tax Matters Partners
The term “tax matters partner” will be obsolete. Instead, authority to act for a partnership will lie in a “partnership representative” who is a person (not necessarily a partner) with a substantial presence in the United States designated by the partnership. The statute imposes no limits on the representative’s authority, and all communications from the IRS go only to the partnership and the partnership representative, not to individual partners (except for the representative, if a partner).
Most, or all partnership agreements do not contemplate the breadth of authority given by the Act to partnership representatives, especially to make the new elections and other actions that partnership representatives may take (or not take) for their partnerships.
Amending the Partnership Agreement
The new regimen makes it prudent, even necessary, for partnerships (including LLCs taxed as partnerships) to review their partnership (or operating) agreements.
Each partnership’s resolution of the questions raised should be written into its partnership agreement. The following suggestions assume that the primary objective of the typical partnership (and partners) is to impose the burdens (and benefits) of partnership adjustments on the reviewed year partners in the reviewed year proportions.
- As a stopgap should all else fail, partnership agreements should include an indemnity in favor of the partnership from each partner and former partner for payments by the partnership attributable to the share of the adjustments of that partner or affected former partner.
- If the Section 6221(b) election out of the new regimen is available, a partnership should take it (It must be filed for any year with the return for that year). The election is not currently available to tiered partnerships, so consideration should be given to avoiding tiered partnerships when possible.
- The partnership agreement should require that the partnership representative forward to each partner and affected former partner copies of all or selected correspondence to or from the partnership that is material to any IRS proceeding under the new regimen, and direct the partnership representative generally to exercise his, her, or its authority in important situations only with notice to all partners and affected former partners and in compliance with the written directions (if any) of some group.
- If the new regimen applies, and the partners and their respective partnership interests in the adjustment (current) year are NOT materially different from those in the reviewed year, it may be acceptable to handle the adjustments under the basic rule of the new regimen.
- If the new regimen applies, and the partners and their respective partnership interests in the adjustment (current) year are materially different from those in the reviewed year, the partnership should consider making a serious effort to induce/coerce the reviewed year partners to file and pay tax as contemplated by the amended return mechanism. In routine circumstances, the results as to tax (albeit not necessarily as to interest and penalties) if all reviewed year partners and former partners comply seem to be the same as those that would obtain under pre-TEFRA law. An inducement to the affected partners and former partners to take the actions contemplated by the amended return mechanism would be a threat by the partnership to make a passthrough election if a satisfactory result is not reached by application of the amended return mechanism. Among the incentives provided by such a threat would be the relative disadvantages of the election (as compared with action under the amended return mechanism), particularly the extra two points of interest applicable in connection with a passthrough election.
- Even while the partnership is working on achieving an optimal result under the amended return mechanism, it should be actively considering the effects of making a passthrough election, because the deadline for making such an election is set by the issuance of a notice of final partnership adjustment, and such a notice can be issued as early as on the deadline for action to take advantage of the amended return mechanism. By the deadline, the partnership should probably have: all but decided on whether or not to make a passthrough election; and if the election is to be made, prepared whatever is necessary (i) to seek partners’ (and, if applicable, former partners’) approval of the election, and (ii) to make the election.