What accountants need to know about the BBA

Editor: Byron Shinn, CPA

It has been seven years since the Bipartisan Budget Act of 2015 (the BBA), P.L. 114-74, significantly changed the rules and procedures governing federal income tax audits of partnerships, effective for tax years beginning in 2018. Nonetheless, as the first audits subject to those rules are only recently starting to conclude, practitioners are slowly discovering all the open items causing difficulties that were not written into the statute or regulations. It is important to pay attention to many of the rules that were included so that the proper structure is in place when the inevitable problems arise. In particular, the BBA made significant changes to the partnership audit procedures, of which tax practitioners should be aware as they prepare Forms 1065, U.S. Return of Partnership Income, each year.

Partnership representative

Whereas prior law had the concept of a “tax matters partner,” the BBA requires each partnership to appoint a “partnership representative” to handle partnership audits. Each partnership subject to the BBA must designate a partnership representative for each year on its Form 1065 for that year. If the partnership representative is an entity, the partnership must also appoint a “designated individual” to act on the partnership representative’s behalf. After an IRS audit has begun, a partnership may revoke its designation of a partnership representative or designated individual by filing a form with the IRS, provided that the partnership also designates a successor.

While, at first glance, this might seem a change only in the name of the person responding to an IRS audit, every partnership should give serious consideration to this appointment. Accountants should check with their clients as to who should be named the partnership representative and not simply use the same person or entity that had previously been listed as the tax matters partner. Unlike under prior law, the partnership representative need not even be a partner in the partnership and can effectively be any person or entity that has at least a minimal presence in the United States.

The BBA grants much more power to the partnership representative to make decisions with respect to partnership audits than the tax matters partner had under the old TEFRA (Tax Equity and Fiscal Responsibility Act of 1982, P.L. 97-248) partnership rules. Under Sec. 6223 and applicable Treasury regulations, the partnership representative (and, if applicable, the designated individual) has the sole authority to act on behalf of the partnership for purposes of the BBA. No other person is even permitted to participate in any administrative proceeding relating to the partnership without the IRS’s consent. Thus, under the BBA, the partnership representative is permitted to take many actions, such as settle audits, agree to extend the statute of limitation, make any relevant elections, and seek judicial review of IRS adjustments. Once the partnership representative makes such a decision with respect to an audit, the decision is final, and no partner has the right to contest it under the BBA. All partners are bound by the partnership representative’s decisions. While the designation of a partnership representative can change from year to year, the audit of any particular year will be handled by the person named on that year’s Form 1065.

Furthermore, Sec. 6231 requires the IRS to mail notices of audits and notices of proposed and final adjustments to the partnership and the partnership representative but not to the partners themselves. Therefore, some partners might not even be aware an audit is taking place.

One way that partners may try to protect themselves from actions taken by the partnership representative is to create their own contractual restrictions on the actions of the partnership representative in the partnership agreement or elsewhere. For example, many partnership agreements entered into after the BBA was enacted provide that the partnership representative must obtain the consent of a certain number or percentage of partners before making certain major decisions, such as settling audits or seeking judicial review of any IRS adjustments. However, such contractual restrictions do not bind the IRS. For example, if a partnership representative settles an audit in violation of the terms of the partnership agreement, the partners may have a cause of action against the partnership representative, but they cannot contest the underlying adjustment with the IRS, as the Service can rely on the partnership representative’s action.

Moreover, depending on the circumstances, a private cause of action by the partners against the partnership representative may be of limited benefit. For example, the partnership representative might be an entity with limited or no assets against which the partners could collect a judgment. Or, in some cases, the partnership agreement may require the partnership to indemnify the partnership representative for any liabilities it incurs in such capacity. Therefore, partners should think carefully about whom to appoint as partnership representative and should ensure that the partnership agreement and other relevant documents contain appropriate protections. When preparing the partnership tax return, accountants should make sure that the partners have made a conscious decision to pick a partnership representative.

Payment of tax and ‘push-out’ election

The most fundamental change in the BBA relates to the payment of any additional tax the IRS assesses as a result of a partnership audit. Under Sec. 6221(a), the general rule under the BBA is that all partnership-related items are determined, assessed, and collected at the partnership level rather than at the partner level. This is a momentous change from the TEFRA partnership rules and upends the general principle that partnerships are flowthrough entities that pay no income tax themselves.

Under Sec. 6225, if the IRS adjusts partnership-related items as a result of an audit, the adjustments are first netted against each other to the extent permissible under applicable regulations. After taking into account these netting rules, if there is a positive adjustment (i.e., the IRS determines that net income was underreported), then the IRS will generally determine the tax at the partnership level by applying the highest marginal tax rate in effect for the year being reviewed. The resulting tax is referred to as an “imputed underpayment.”

There are several disadvantages to this system. First, having the partnership pay the imputed underpayment may result in economic distortion among the partners. Absent some sort of contractual protection, the partners in the partnership as of the time the imputed underpayment is paid would generally bear the burden of the payment, and those partners may be different from the partners that existed during the tax year under audit (the “reviewed year”).

Second, if a partnership simply pays the tax attributable to an imputed underpayment without taking any further action or making any elections, it may end up significantly overpaying the tax, compared with the tax that the partners would have owed if the partnership had correctly determined its income in the first place. For example, some of the additional income might have been allocated to tax-exempt partners or to partners with net operating losses if the partnership’s income had been correctly determined by the partnership in the reviewed year. In addition, the income might have been taxable at long-term capital gains rates instead of the highest marginal tax rate on ordinary income.

To help ameliorate this result, Sec. 6225(c) and the regulations thereunder provide procedures for the partnership representative to request a modification of a proposed imputed underpayment, based on a number of factors. For example, a partner may choose to amend the partner’s tax return for the reviewed year in order to take into account and pay tax on the partner’s share of the additional income attributable to the imputed underpayment. In such a case, the partnership representative may request that the IRS reduce the amount of the imputed underpayment by the amount so taken into account. In addition, if the partnership representative can demonstrate to the IRS that a portion of an imputed underpayment would have been allocable to a tax-exempt partner, that portion of the imputed underpayment can be reduced.

Another possible adjustment relates to the applicable tax rate: If the partnership representative can show that a portion of the income attributable to the imputed underpayment would have been allocated to partners who would have been taxed on it at long-term capital gains rates or corporate tax rates, then the imputed underpayment can also be reduced accordingly. Additional decisions are left to the partnership representative’s authority, further indicating that careful consideration should be given when naming that person on a Form 1065.

Even if the partnership representative uses these modification procedures, the associated benefits might be limited. Unless all of the partners in the partnership agree to file amended returns for the reviewed year, which is often not feasible, the partnership would likely still end up owing tax attributable to an imputed underpayment. Some partners may have transferred their interests in the partnership between the reviewed year and when the imputed underpayment is determined, and such partners would have no incentive to voluntarily cooperate absent some sort of contractual protection (such as a restriction in the partnership agreement or applicable transfer document). In addition, if only some partners choose to amend their tax returns for the reviewed year, then the partners as a whole would generally bear the burden of the remaining imputed underpayment, which would be unfair to the partners that amend their returns and pay their respective shares of the tax individually.

Fortunately, the BBA provides an important remedy to these problems and gives even more authority to the partnership representative. Under Sec. 6226, within 45 days of receiving a notice of final partnership adjustment, the partnership representative can make an election to “push out” the imputed underpayment to its partners for the reviewed year. If this election is made, then each partner for the reviewed year generally must pay tax equal to the amount of tax that the partner would have owed if the partner had taken into account the adjustment for the year, and the partner’s tax attributes are adjusted accordingly. In such a case, the additional tax (and any interest and penalties) are assessed and collected from the partners for the reviewed year, and the partnership itself is not liable for the amounts. This seems to put partners in the same place they would have been in under the TEFRA partnership rules. However, this option does not come without a cost. If the partnership representative makes the Sec. 6226 election, the partners must pay interest on any tax liability at a rate 2 percentage points higher than the usual underpayment rate in Sec. 6621. If the partnership itself pays the tax, it simply pays the Sec. 6621 underpayment rate without the additional 2-percentage-point penalty.

The Sec. 6226 push-out election is usually the most economically appropriate way to deal with an audit adjustment, as it generally allocates the burden of any additional income to the partners in the reviewed year who would have been allocated such income had the partnership properly taken into account the income in the first place. However, it comes at the cost of an increased interest rate. Thus, partnerships with small adjustments may choose to simply pay the tax themselves in accordance with the procedures of Sec. 6225.

Again, the partnership representative has the sole power to decide whether to make the push-out election. Without adequate contractual protections, this could easily lead to abuse. For example, assume that a partner of a partnership owns the majority of the partnership interests during the year under audit and is designated as the partnership representative for that year. Assume further that by the time the IRS has concluded its audit and proposed an adjustment, the partnership representative has sold a significant portion of his partnership interest but has remained partnership representative for the year under audit.

If the other partners have not negotiated contractual protections, the partnership representative could simply choose to have the partnership pay the imputed underpayment rather than make the Sec. 6226 election. Unless the partnership agreement provides otherwise, this would cause the current partners to bear the burden of the tax rather than the partners for the tax year under audit (including the partnership representative). The partners could avoid this result by including a provision in the partnership agreement that requires the partnership representative to make the push-out election or requires the partnership representative to obtain the consent of a certain percentage of the partners before making major decisions.

The above discussion primarily focuses on adjustments that result in an imputed underpayment. If a partnership has a negative adjustment (in other words, the IRS determines that the partnership overstated its taxable income), the BBA can sometimes produce strange results, and, depending on a partner’s particular circumstances, it might not always be possible for the partner to receive the benefit of the adjustment. While this issue is beyond the scope of this column, it has been raised with IRS personnel with hopes that future modifications to the statute or regulations can fix the uncertainty.

Election out of the BBA

Given the complications of the BBA described above, partnerships may prefer that the BBA not apply in the first place. Under Sec. 6221(b), certain partnerships may elect out of the BBA. However, this election is limited. To qualify for any given tax year, a partnership must have fewer than 100 partners during the year, and each partner must be an individual, a corporation, any foreign entity that would be treated as a C corporation were it domestic, an S corporation, or the estate of a deceased partner. If any partner in a partnership is a trust, another partnership, or even a disregarded entity, the partnership will be disqualified from making the opt-out election. Thus, it is likely that all but the simplest partnerships would not be able to benefit from this rule. As with all elections, the partnership representative has the sole authority to make the Sec. 6221(b) election, so partners should negotiate contractual protections if they would like to ensure that this election is made.

Take precautions

The partnership audit rules enacted under the BBA are unintuitive and extremely complicated. Moreover, the BBA gives significant power to the partnership representative to make important audit decisions that could greatly distort the economic arrangements that the partners had agreed to. To protect themselves, partners should be careful in selecting a partnership representative and should make sure that the partnership agreement and other relevant documents contain sufficient protections if the partnership representative does not take the actions that the partnership desired and expected.

For more information, access the AICPA Tax Section’s BBA Partnership Audit and Adjustment Rules Frame-work for guidance and tools necessary to advise clients. This resource also includes a statutory and regulatory timeline covering this momentous tax examination reform.

Contributors

Ellen S. Brody, CPA, J.D., LL.M., and Charles S. Nelson, J.D., are both partners with Roberts & Holland LLP in New York City. Brody is also a member of the AICPA Tax Practice and Procedures Committee. For questions about this column, contact thetaxadviser@aicpa.org.