New Partnership Tax Audit Rules
The Bipartisan Budget Act of 2015 establishes new rules (the “New Partnership Audit Rules”) for the conduct of federal income tax audits of partnerships and the assessment and collection of income taxes resulting from such audits.
This article provides a brief summary of certain aspects of the New Partnership Audit Rules and also raises a few related issues to be considered by partnerships, partners and prospective investors in partnerships. While this article uses partnership terminology, the concepts addressed herein are also applicable to limited liability companies that are treated as partnerships for income tax purposes and the members of such limited liability companies.
Principal Aspects of New Partnership Audit Rules
- Effectiveness. The New Partnership Audit Rules are effective for taxable years beginning after December 31, 2017.
- Potential for Assessment of Tax Against Partnership. Under the new rules, audit adjustments can result in an assessment of tax against the partnership that is the subject of the audit (described as an “imputed underpayment”).
- Election Out. Partnerships meeting certain requirements will be able to elect out of application under the new rules, thereby avoiding any imputation of tax to the partnership. The election is made on a year-by-year basis. Generally, the election will not be available to any partnership that has more than one hundred partners or that has any partner that is not an individual, a deceased partner’s estate, a C corporation, or a foreign entity that would be required to be treated as a C corporation if it were a domestic entity. Accordingly, partnerships that have other partnerships as partners will not be able to elect out. In certain circumstances, having an S corporation as a partner will not preclude a partnership from electing out.
- Calculation of Imputed Underpayment, Generally. The imputed underpayment generally is calculated by (a) netting all adjustments of items of income, gain, loss or deduction; (b) multiplying the net amount by the highest rate of tax in effect for the reviewed year applicable to individuals or corporations; and (c) increasing or decreasing the resulting product by any adjustments to items of credit for the reviewed year.
- Exclusion for Adjustments Taken into Account by Partners. Excluded from the calculation of an imputed underpayment are any adjustments that are taken into account on returns filed by one or more partners for their taxable years that include the end of the reviewed year, if payment of any tax due is included with such returns. Accordingly, a partnership’s partners generally will be able to reduce, and perhaps eliminate, an imputed underpayment by filing amended returns reflecting their respective shares of any adjustment and paying the resulting tax.
- Pass-Through Election. As an alternative to paying an imputed underpayment, a partnership may elect to furnish to the IRS and to each partner of the partnership for the reviewed year (a “reviewed year partner”) a statement of the partner’s share of any adjustments. If the partnership makes this election (the “Pass-Through Election”), each reviewed year partner’s income tax for the taxable year which includes the date of the statement is increased by (a) the amount by which the partner’s income tax for the taxable year of the partner which includes the end of the reviewed year would increase if the partner’s share of the reviewed year adjustment amounts were taken into account for such taxable year of such partner, plus (b) the amount by which the partner’s income tax would increase by reason of adjustments to tax attributes in taxable years of the partner beginning after the taxable year of the partner that includes the end of the reviewed year but before the beginning of the partner’s taxable year that includes the date of the statement. One drawback to making the Pass-Through Election is that interest would accrue at a rate that is two percentage points greater than the rate that typically applies to underpayments of federal income tax.
- Partnership Representative. The new rules provide for the appointment of a “partnership representative” by a partnership. The partnership representative will have broad authority to act on behalf of the partnership in connection with a federal income tax audit.
Issues to Consider
- Partnership Agreements. Existing and newly-formed partnerships will want to consider whether their partnership agreements should be drafted (or amended, in the case of partnerships with existing agreements) to:
- Require the partnership to elect out of the New Partnership Audit Rules for any taxable year with respect to which that election is available;
- Require the partnership to make (or to prohibit it from making) the Pass-Through Election absent some specified level of consent from the partners;
- Obligate current and former partners to amend their tax returns to take into account their respective shares of any adjustments for purposes of reducing or eliminating the amount of any imputed underpayment;
- Describe how any payment of an imputed underpayment by the partnership will impact the partners’ respective rights to share in future distributions (e.g., whether such payments will be allocated among the partners and treated as advances against future distributions);
- Provide a mechanism for appointing and replacing the partnership representative; and
- Require a specified level of partner consent for certain actions by the partnership representative (e.g., entering into any agreement or settlement with a tax authority, taking any judicial action or extending any statute of limitations).
- Potential Investment. A prospective investor in a partnership will want to consider requiring that the partnership agreement address how audits under the New Partnership Audit Rules will be handled (including under what conditions different elections will be made) and that the investor’s approval be required for any amendment of or departure from such provisions.
- Redemption or Transfer. As part of negotiating a buyout or sale, a partner whose partnership interest is being redeemed or sold might request that the partnership or transferee agree to indemnify the partner for any tax that might result from a Pass-Through Election (or otherwise obtain an agreement by the partnership not to make the Pass-Through Election without the partner’s consent).
- Determination of Optimal Approach. Partnerships facing adjustments under the New Partnership Audit Rules and their partners will want to determine the optimal method for addressing such adjustments—i.e., have the partnership pay the imputed underpayment, have the partners amend prior year returns to take into account the adjustments or have the partnership make the Pass-Through Election. While some partnerships might initially be inclined to avoid entity-level tax, having the partnership pay the imputed underpayment might produce the best outcome in certain circumstances.
- One reason is that the assumed rate of tax for purposes of calculating the imputed underpayment does not take into account the 3.8% tax on net investment income or, perhaps more importantly, the tax on self-employment income, whereas such taxes could be due from partners if they amend their returns to take into account audit adjustments.
- Also, limitations on deductions and losses that might apply if partners were to amend prior year returns to include their shares of adjustments (or that might apply in calculating tax due from partners if the Pass-Through Election is made) would not apply in calculating the amount of an imputed underpayment. Examples of such limitations include itemized deduction phase-outs, limits on deductibility of net capital losses and limits on deductibility of charitable contributions.
For more information about the New Partnership Audit Rules, contact a member of Smith Anderson’s Tax Group, business lawyers who understand taxation.