By James Nitsche
The Bipartisan Budget Act of 2015 (the “BBA”) made sweeping changes to the rules governing federal income tax audits of entities taxed as partnerships. The BBA rules replace partnership audit rules that were created by the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”). In general, under the TEFRA audit regime, when a partnership is audited, the partners in the partnership have an opportunity to participate, and any adjustments resulting from the audit are made on the partners’ returns for the affected tax years. In contrast, unless a partnership is eligible to elect out of the BBA regime or the partnership makes a “push out” election, the BBA rules impose an entity-level tax on the partnership that effectively is borne by the persons who are partners during the tax year in which the adjustments are made.
The BBA rules are intended to streamline partnership audits so as to make it easier for the Internal Revenue Service (“IRS”) to assess and collect any deficiencies resulting from a partnership audit. While the new rules were enacted in 2015, they do not apply until tax years beginning after December 31, 2017. Thus, the impact of the BBA rules may not be fully realized until the IRS starts auditing 2018 returns. Because the BBA brings fundamental changes to the potential ramifications of partnership tax audits, however, every partnership will want to modify its existing governing documents in an effort to address those potential ramifications. In doing so, partnership advisors will need to consider that the BBA provides three distinct options for how the new rules can apply – the default rule; the push-out election; and the small partnership election – and determine which of those options is appropriate under the circumstances.
The Small Partnership Election. A partnership with 100 or fewer partners may elect out of the BBA audit rules for any tax year, provided each of its partners is an “eligible partner.” For this purpose, an eligible partner means a partner who is an individual; a C corporation; an S corporation; an estate of a deceased partner; or, a foreign entity that would be treated as a C corporation if it were a domestic entity. Accordingly, a partner is not an eligible partner, and the partnership in which such partner is a partner is not an eligible partnership, if the partner is a partnership; a trust (including a grantor trust); a foreign entity that is not described in the preceding sentence; a disregarded entity (e.g., a single-member limited liability company that has not elected to be taxed as a C corporation or S corporation); a nominee or similar person who holds a partnership interest on behalf of another person; or an estate of an individual other than a deceased partner.
For purposes of this election, a partnership has 100 or fewer partners if the partnership is required to furnish 100 or fewer Schedule K-1s for the tax year. Thus, if a partnership interest changes hands during the tax year, each holder of the interest counts toward the 100-partner limit. In addition, a partnership with a partner that is an S corporation must take into account the number of Schedule K-1s required to be issued by the S corporation to its shareholders for the tax year of the S corporation ending with or within the tax year of the partnership. So if an S corporation partner has, say, 40 shareholders, those 40 shareholders are taken into account in determining whether the partnership has no more than 100 partners. Finally, an S corporation is an eligible partner even if one or more of its shareholders would not be an eligible partner (e.g., an electing small business trust).
In order for an eligible partnership to elect out of the BBA rules for a particular tax year, the partnership must (i) include the election with its timely-filed return (including extensions) for that year; (ii) provide the name, taxpayer identification number and federal tax classification of each partner, along with an affirmative statement that the partner is an eligible partner, and (iii) notify each of its partners of the election within 30 days of making the election.
If an eligible partnership makes the small partnership election for a tax year, the IRS may still audit the partnership, but must make all adjustments at the partner level. Hence, where the election is made, the partnership has no authority to settle issues on behalf of the partners or extend the statute of limitations on assessments.
Perhaps the most likely candidate for the small partnership election is a partnership that includes a limited number of sophisticated partners, each of whom is an eligible partner and each of whom is sufficiently advised. Where the parties find it advisable to make such election, the partnership agreement will need to include provisions (i) directing the partnership representative to make the election annually unless otherwise directed in writing by vote of the partners and (ii) limiting the ability of any partner to transfer a partnership interest to any person that is not an eligible partner without the written consent of the other partners.
The Default Rule. If a partnership cannot or does not make the small partnership election, the BBA audit rules will govern any federal income tax audit of the partnership. Consequently, unless the partnership makes a push-out election, the general default rule will apply.
Under the default rule, the IRS will audit the partnership’s items of income, gain, loss, deduction, credit and the partners’ distributive shares for a particular tax year of the partnership (the “reviewed year”) at the entity level. Any adjustment, and any assessment and collection of tax, interest and penalties, made with respect to the reviewed year will be taken into account at the entity level and applied in the year in which the adjustment is made (the “adjustment year”). If the adjustment results in a deficiency, the partnership will be required to pay in the adjustment year the “imputed underpayment” of tax, interest and penalty, with any tax underpayment being calculated at the highest tax rate in effect for the reviewed year. Conversely, if the adjustment results in an overpayment with respect to a reviewed year, any refund will be made to the partnership in the adjustment year.
The typical family partnership is a likely candidate for the default rule, since such a partnership often will include partners that are not eligible partners for purposes of the small partnership exception (e.g., trusts). In addition, such partnerships are not likely to see frequent changes in the makeup of the partners, with the result that reviewed year and adjustment year partners (or their heirs) will generally be the same.
The Push-Out Election. As an alternative to the default rule, a partnership that receives a notice of adjustment may elect to have any adjustments “pushed out” to persons who were partners during the reviewed year through the issuance of amended Schedule K-1s for the reviewed year. This result is similar to the TEFRA rules, but instead of the deficiency being imposed with respect to the reviewed years (which would require amended returns to be filed), the deficiency is reported on and paid with the reviewed year partners’ returns for the adjustment year.
Where the push-out election is made, the persons who were partners during the reviewed year(s) are liable for any tax deficiency attributable to the reviewed year(s). In addition, the reviewed year partners are liable for interest running from the due date for the return for the review year(s) and applicable penalties, with the deficiency interest rate being increased by a “toll charge” of two percentage points above the normal underpayment rate.
To avail itself of the push-out election, a partnership must elect to issue adjusted Schedule K-1s to all reviewed year partners no later than 45 days after it receives a notice of final adjustment. Provided the partnership does this, the partnership is not liable for any underpayment.
The push-out election would seem to be best suited to partnerships that include partners that are not eligible partners and that are unrelated and sophisticated. Of course, use of the push-out election can be expected to result in tension between current and former partners. This makes it imperative to include appropriate provisions in the partnership’s governing documents to address whether the partnership may or will make the push-out election and, if so, what the respective rights and obligations of the adjustment year and reviewed year partners will be.
The Partnership Representative. The BBA replaces TEFRA’s “tax matters partner” with the “partnership representative.” Under the BBA rules, the partnership representative, which need not be a partner, has exclusive authority to represent the partnership in any audit proceeding and to bind the partnership and its partners by its actions in the proceeding. Moreover, unlike under TEFRA, neither the IRS nor the partnership representative has any obligation to notify the partners of audit proceedings or adjustments. Thus, absent appropriate limitations imposed by a partnership’s governing documents and applicable fiduciary law, the partnership representative has unfettered power over federal income tax matters affecting the partnership and its partners. In view of this, it is imperative that the scope of and limitations on the partnership representative’s obligations be fully addressed in the partnership’s governing documents. Otherwise, the partners, past and present, could suffer consequences not contemplated at the time of admission to or removal from the partnership.
Conclusion. The BBA’s partnership audit rules are truly not “one size fits all.” Which of the three basic options may work beautifully in one instance may prove disastrous in another. Nevertheless, the new rules will shortly become the law of the land as far as partnership federal income tax audits are concerned. Hence, it is imperative that appropriate attention be directed to this matter without delay.