On Nov. 2, 2015, President Barack Obama signed the Bipartisan Budget Act of 2015 (the Act), P.L. 114-74. The Act contained several significant changes to the procedural rules for federal income tax audits and the judicial process applicable to partnerships and other entities classified as partnerships for federal income tax purposes, such as limited liability companies. The changes are a departure from how partnerships have been treated for federal income tax purposes.
In the past, partnerships were treated as flowthrough entities and were not subject to federal income tax. Under the new rules, partnerships are still flowthrough entities, but any taxes due after an audit can be collected from the partnership, saving the IRS from pursuing individual partners. This change was achieved when the Act repealed the current federal audit procedures for partnerships enacted by the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) and replaced them with the following rules. The new rules will have a profound impact on existing and new partnerships.
The federal income tax audit or judicial proceedings will continue to be conducted at the partnership level as under TEFRA, but the first major change is that a tax liability, including penalties and interest, from a federal income tax audit or judicial proceeding will be imposed directly on the partnership and not on the partners individually. Adjustments to the partnership's income, gain, loss, deduction, or credit for a particular year (called the "review year") are taken into account by the partnership in the year that the federal income tax audit or judicial proceeding is completed (called the "adjustment year"). This change shifts the ultimate tax consequences from the partners of the partnership in the review year to the partners of the partnership in the adjustment year.
The tax imposed on the partnership in the adjustment year is calculated by taking all of the adjustments to the partnership's income, gain, loss, deduction, or credit for the review year and netting them together. This net amount of adjustment is then multiplied by either the highest individual or the highest corporate tax rate that was in effect in the review year. This "imputed underpayment" is imposed on the partnership in the adjustment year.
Adjustments to the allocation between partners will not be netted but instead will be taken into account only to increase allocations of income or decrease the allocations of deductions to the particular partner. For example, a partnership may owe an imputed underpayment because of an incorrect allocation of items of income or deduction among partners.
The imputed underpayment may be reduced by (1) the partners filing amended tax returns and making the related tax payment for the review year, (2) applying the correct tax rate to specific partners (such as tax-exempt entities), or (3) considering the type of income subject to the adjustment (such as capital gains). After the proposed partnership adjustment is mailed, the partnership has 270 days to submit the necessary information and documentation to the IRS to modify the imputed underpayment. The IRS must approve all modifications to the partnership's imputed underpayment.
The amended tax return modification rule requires that one or more partners file returns for the tax year of the partner that includes the end of the partnership's reviewed year, the amended returns take into account all adjustments properly allocable to those partners (and for any other tax year for which any tax attribute is affected by reason of those adjustments), and a payment of any tax due is included with the amended returns.
As an alternative to the partnership's paying imputed underpayment itself, the partnership can elect, within 45 days of receiving an IRS final notice of partnership adjustment, to issue statements to the IRS and the partners who were partners in the review year, setting out the partners' share of any adjustment to the partnership's income, gain, loss, deduction, or credit. The partners receiving these statements will be required to take the adjustments into account on their individual tax returns for the year in which the adjustment statements are issued. A reviewed year partner's tax for the adjustment year is increased by the sum of (1) the amount that partner's tax for the reviewed year and for subsequent years before the year the adjustment statements are issued increases from taking the partner's share of the adjustments into account for that year plus (2) the increases in the partner's tax due to the adjustment to tax attributes in those years.
In addition, those partners will owe interest and penalties if applicable. Penalties will be determined at the partnership level. Interest will be determined at the partner level from the due date of the return for the tax year to which the increase is attributable, but the interest rate will be 2 percentage points higher than the rate that normally apples to tax underpayments.
A partnership also has the option to file a request for an administrative adjustment for the review year when the partnership's position is that an additional payment is due or an overpayment was made. The adjustment will be taken into account in the adjustment year at the partnership level. The partnership can also use the alternative method for an administrative adjustment by issuing adjustment statements to each of the partners that were partners in the review year.
These new partnership audit procedure rules are effective for partnership tax years beginning after Dec. 31, 2017. A partnership may elect to apply the new rules for tax years beginning after Nov. 2, 2015, and before Jan. 1, 2018.
On Aug. 5, 2016, the IRS published temporary and proposed regulations for partnerships wanting to elect into the new partnership audit procedural rules. Temp. Regs. Sec. 301.9100-22T and Prop. Regs. Sec. 301.9100-22 provide guidance on how, when, and where a partnership can elect into the new partnership audit regime.
If a partnership chooses to elect into the new partnership audit regime early, the partnership must provide a written statement with the words "Election under Section 1101(g)(4)" written at the top of the election statement. The statement must also include:
- The partnership's name, taxpayer identification number (TIN), and the partnership tax year for which the election is being made;
- The name, TIN, address, and daytime telephone number of the individual who signs the statement;
- An affirmative statement that the partnership is electing the application of Section 1101(c) of the Act for the partnership return for the eligible tax year identified in the notice of selection for examination;
- The name, TIN, address, and daytime telephone number of the partnership representative, as defined under Sec. 6223, and any additional information required by the applicable regulations, forms and instructions, and other guidance issued by the IRS;
The statement must also contain the following representations:
- The partnership is not insolvent and does not reasonably anticipate becoming insolvent before the resolution of any adjustment with respect to the partnership tax year for which the election is being made;
- The partnership has not filed, and does not reasonably anticipate filing, voluntarily, a petition for relief under Title 11 of the U.S. Code;
- The partnership is not subject to, and does not reasonably anticipate becoming subject to, an involuntary petition for relief under Title 11 of the U.S. Code; and
- The partnership has sufficient assets, and reasonably anticipates having sufficient assets, to pay a potential imputed underpayment with respect to the partnership tax year that may be determined under Subchapter C of Chapter 63 of the Internal Revenue Code as amended by the Act.
- The statement is signed under penalties of perjury, that the individual signing the statement is duly authorized to make the election, and that, to the best of the individual's knowledge and belief, all of the information contained in the statement is true, correct, and complete.
The statement must be dated and signed by the tax matters partner, as defined under Sec. 6231(a)(7) (before amendment by the Act, i.e., under TEFRA) and the applicable regulations, or an individual who has the authority to sign the partnership return for the tax year under examination under Sec. 6063, the regulations, and applicable forms and instructions.
Under the new partnership audit rules the "tax matters partner" designation for federal income tax audits or judicial proceedings was repealed and replaced by the "partnership representative." Each partnership needs to designate a partnership representative who is a person, not necessarily a partner, with a substantial presence in the United States. If the partnership has not designated a partnership representative, the IRS will select one.
The partnership representative is the only person who will receive notice of any administrative proceeding that has been initiated, notice of any proposed partnership adjustment, and notice of any final partnership adjustment. The partnership representative has the sole authority to act on behalf of the partnership during a federal income tax audit or judicial proceeding. The partnership representative's decisions have a binding effect on the partnership and all of its partners in a federal income tax audit or judicial proceeding.
To elect into the new partnership audit regime early, the partnership must have designated a partnership representative and provided the necessary information on the election statement. The election statement must be signed by the tax matters partner or the individual with the authority to sign the partnership return under review, but not the partnership representative (if different). The partnership must make this election within 30 days of the date of notification to the partnership, in writing, that a tax return of the partnership for an eligible tax year has been selected for examination by a notice of selection for examination. An eligible tax year means any partnership tax year that begins after Nov. 2, 2015, and before Jan. 1, 2018, with a few exceptions. Those exceptions are:
- If the tax matters partner has filed an administrative adjustment request under Sec. 6227(c) (under TEFRA);
- The partnership is deemed to have filed an administrative adjustment request under Sec. 6227(c) (also under TEFRA); or
- An amended return of partnership income has been filed or has been deemed to be filed for the partnership tax year.
Upon the receipt of a valid election, the IRS will mail, not before the date that is 30 days after receiving a valid election, a notice of administrative proceedings to the partnership and the partnership representative.
A partnership that has not been issued a notice of selection for examination can still make an election for the partnership for an eligible tax year for the purpose of filing an administrative adjustment request under current Sec. 6227. No election for an administrative adjustment request can be made before Jan. 1, 2018, unless the partnership has been issued a notice of selection for examination. If an administrative adjustment request is filed before Jan. 1, 2018, it will be deemed to have been filed under Sec. 6227(c) (TEFRA).
Todd D. Radde (email@example.com) is a tax lawyer at Taylor English Duma in Atlanta. He has experience in a wide variety of tax law areas, having worked in a Big Four accounting firm, law firms, and a Fortune 100 company.
A version of this article previously appeared on the Taylor English website.