Changes to BBA Enact New Partnership Audit Rules
Under the Bipartisan Budget Act of 2015 (“BBA”), which will take effect in 2018, the IRS will be able to audit certain partnerships and limited liability companies (LLCs) and collect the tax resulting from the adjustment at the partnership level. This makes for new partnership audit rules that were originally enacted in 1982 under TEFRA. According to a Crains Cleveland report, this change is significant because it allows the IRS to collect tax revenue directly from partnerships. Currently, TEFRA only enables the IRS to collect any taxes owed from individual partners in a partnership.
The genesis of this change is the number of tiered partnerships and large partnerships make it difficult and time consuming for the IRS to flow through changes to many individual partners and multi-tiered partnerships. IRS believes it can raise billions in revenue by eliminating the need to adjust each partner’s personal return or to push the adjustment through to each one of several tiered partnerships.
What partners should consider
Below are key considerations for partners now:
- Partnership representative
This is a role designated by one of the members of a partnership. Under TEFRA, a partnership would designate a Tax Matters Partner to coordinate tax audits. The role itself has limited authority over a partnership under current TEFRA rules. But Bloomberg BNA noted that under the new law (Bipartisan Budget Act of 2015) that this role will be shifted over to the partnership representative, who will have authority over the partnership tax audits and the authority to bind the partnership and its partners.
This role will allow the partnership representative to make final decisions on audits and other tax proceedings such as whether to pursue litigation. The significant aspect of the partnership representative though is that he or she does not need to be an existing member of the partnership. In fact, if not selected by the members of the partnership, the IRS can appoint one. This is a change worth noting because the partnership representative will have ultimate authority, even if the authority is not granted in the partnership or operating agreement. Perhaps the most significant issue is the ability to make a push-out election whereby the partnership shifts the adjustment to the partners in the year under audit.
- Conflict of interest
Since it is possible that a partnership representative would have a conflict of interest in acting on behalf of the partnership, consideration should also be given to imposing some level of fiduciary duty on the partnership representative or at least allow the possible replacement of the partnership representative if it appears that there is a conflict of interest. Other provisions might include the duty to inform, to allow participation in the audit and to require certain elections to be subject to vote.
- Tax adjustment
It is important to note that the tax on the partnership audit adjustment is no longer the sum of the individual deficiencies of the partners; instead, it is the adjustment multiplied by the highest marginal tax rate (Applicable Highest Tax Rate) for the tax year under audit (“Reviewed Year”). The year in which payment of the tax adjustment is made is called the Adjustment Year and is the direct responsibility of the partnership and indirectly of the current partners.
Now, partnership agreements will have to address potential future tax adjustments through the use of indemnification provisions or escrows. Certainly, purchase and sale agreements will face this issue.
- Opting out
A partnership may opt out of the new rules if the partnership issues 100 or less K-1s and if all the partners are individuals, C corporations, S corporations, a deceased partner’s estate or a foreign entity taxed as a C corporation. A partnership will not be able to elect out if a trust or a partnership is a partner.
The significance of the new rules
With the significance of the changes in how partnerships are taxed, as well as the replacement of the tax matters partner with the partnership representative, these entities should review their current partnership or operating agreements now to adjust. This is particularly important because it may cause partnerships to dissolve entirely, or significantly change the operating agreements to restrict the authority of a partnership representative as much as possible.
Are you still unsure how these new partnership audit rules will affect you? Contact me, Frank Brunetti, to discuss the matter further.