The Bipartisan Budget Act (BBA) of 2015, P.L. 114-74, marked a major change in how the IRS will approach partnership audits in the future. The act, which generally applies to returns filed for partnership tax years beginning in 2018, repeals the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) and electing large partnership regimes that currently govern partnership administrative procedures. In their place, it imposes a new, centralized system for the audit, adjustment, assessment, and collection of partnership-related taxes. Certain partnerships, however, will have the ability to elect out of the new regime.
Under the BBA, partnership adjustments will generally be assessed and collected at the partnership level. This represents a fundamental change from current practice that is in tension with the general flowthrough treatment that has historically been accorded to partnerships under Subchapter K principles. This shift is, in large part, a reaction to a growing awareness that the IRS struggles to audit large partnerships and (just as importantly) to make assessments against their partners under the existing TEFRA regime.
Which Partnerships Will Be Subject to the New Rules?
The new rules will generally apply to all partnerships. However, partnerships that satisfy certain requirements and that have 100 or fewer qualifying partners will have the option to elect out of the new regime. Where such an election out is made, the partnership and its partners will be governed by the present-law deficiency procedures (Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in 2015, p. 58 (March 2016)) rather than the BBA's "imputed underpayment" procedures, which are discussed below.
A partnership is eligible to elect out of the new rules, however, only if each of its partners is either an individual, a C corporation, a foreign entity that would be treated as a C corporation if it were domestic, an S corporation, or an estate of a deceased partner (Sec. 6221(b)(1)(C)). (As written, the statute does not clearly address several important issues, including whether a partnership with a partner that is a single-member disregarded entity will be rendered ineligible to opt out, although the legislative history behind the BBA indicates that Treasury may provide future guidance on this issue.) If a partnership consists exclusively of partners in the above-listed categories, it may elect out of the new audit rules if all of the following conditions are satisfied (Sec. 6221(b)(1)):
- The partnership makes a valid election for the tax year;
- The election is made with a timely filed return for the tax year and includes a disclosure of the name and taxpayer identification number (TIN) of each partner;
- The partnership notifies each partner of the election; and
- The partnership is required to furnish 100 or fewer statements under Sec. 6031(b) (Schedules K-1) to its partners.
As this demonstrates, the election-out process is not a particularly simple one. The partnership must meet each of the listed requirements or it runs the risk that an election out will not be valid. It is also critical to note that the election out must be made with a timely filed partnership return and that the election is valid only for that year, so it must be made every year to remain in effect.
Of particular note, the new regime provides special rules in the S corporation context when it comes to the 100-or-fewer-statements rule. If one or more of the partnership's partners is an S corporation, the partnership must provide a disclosure of the name and TIN of each person to whom the S corporation is required to provide a statement (i.e., a Schedule K-1) for the tax year (Sec. 6221(b)(2)(A)). These statements (which are required to be furnished by the S corporation partner to its shareholders) are treated as statements required to be issued by the partnership for purposes of the 100-or-fewer-statements rule (Sec. 6221(b)(2)(A)). In many cases, this could prove to be a particularly difficult requirement to satisfy—after all, it requires knowledge of both the number and identity of S corporation shareholders who may otherwise be unrelated to the partnership.
The Imputed Underpayment: A Shift to Entity-Level Liability
Under the BBA, the IRS will generally audit partnerships at the partnership level. Adjustments, as well, will generally be determined at the partnership level, and any tax attributable to those adjustments—called an "imputed underpayment" under the act—will generally be assessed against the partnership in the year of the adjustment (Sec. 6225(a)(1)).
How is the imputed underpayment calculated? As a general rule, the overall imputed underpayment is determined by netting all of the partnership adjustments and multiplying the net adjustment by the highest rate of tax applicable under Sec. 1 or 11 to individuals or corporations for the reviewed year (Sec. 6225(b)(1)). However, the BBA provides several mechanisms that allow for the modification of the amount of the calculated imputed underpayment (Sec. 6225(c)).Under the modification procedures, the partnership will be relieved from the imputed underpayment liability to the extent that reviewed-year partners file amended returns that take into account the partnership adjustment and pay any tax due (Sec. 6225(c)(2)). The partnership can also reduce the imputed underpayment to the extent that it demonstrates that:
- A portion of the imputed underpayment is allocable to a partner that would not owe tax because of its status as a tax-exempt entity for the reviewed year (Sec. 6225(c)(3));
- A portion of the imputed underpayment is allocable to a C corporation that is subject to a lower tax rate than the rate applicable to individuals; or
- A portion of an imputed underpayment relates to an item of long-term capital gain or qualified dividend income that is allocable to a partner who would be subject to a lower tax rate (Sec. 6225(c)(4)).
Notably, however, the onus is on the partnership to establish that any such modification procedures apply, and any information or documentation necessary to establish the applicability of the procedures must be provided within 270 days from the date the notice of a proposed partnership adjustment is mailed.
In addition, the BBA provides another procedural mechanism—a so-called push-out election—that allows a partnership to shift the partnership-level "imputed underpayment" liability to the reviewed-year partners (i.e., those partners who were partners during the prior year(s) being audited). When such a push-out election is properly made, each reviewed-year partner becomes responsible for its share of the adjustments (Sec. 6226(b)). Push-out elections must be made within 45 days after the notice of final partnership adjustment, so partnerships would be well-advised to proactively address this election (and other aspects of the BBA) in their partnership agreement (Sec. 6226(a)(1)).
The BBA's new partnership rules will have a significant impact on partnerships and their partners in the future. They mark a fundamental change in the partnership regime, overhauling the current audit and administrative rules under TEFRA and the electing large partnership regimes. But the changes will not only affect procedural rules and technicalities—they will also affect the underlying economic valuation of partnership interests and the legal rights of partners as well. And while, for some, that reality is poised to set in after the new rules finally take effect, many are proactively addressing BBA issues in their partnership agreements, preparing for the changes to come.
Valrie Chambers is an associate professor of accounting at Stetson University in Deland, Fla. Jason B. Freeman is managing member at Freeman Law PLLC in Dallas/Fort Worth and an adjunct professor of law at Southern Methodist University’s Dedman School of Law in Dallas. Mr. Freeman is a member of the AICPA Tax Practice & Procedures Committee. For more information about this column, contact firstname.lastname@example.org.