The Bipartisan Budget Act of 2015 (P.L. 114-074) was signed into law on November 2, 2015. This Act represents a major overhaul of Internal Revenue Service audit procedures applicable to partnerships and limited liability companies taxed as partnerships and their owners. The Act is likely to require amendments to existing partnership, operating, tax allocation, and other agreements which affect income tax audits taking place for years beginning in 2018. Current buyers and sellers of businesses will also need to consider the effect of the Act on their transactions.
The Act appears to be motivated by congressional desire to increase the number of partnership audits, primarily due to perceived abuses, and to simplify and shift collection of tax resulting from an audit of a partnership likely due to alleged underfunding of the Internal Revenue Service.
The Act replaces the current audit rules which have been in place for over thirty years. And, unlike previous law, the Act generally contemplates an integrated system of audit, adjustment, and collection of tax from the partnership and not from the individual owners. The Act is effective for tax years beginning after December 31, 2017 unless a partnership elects to apply the rules earlier.
Highlights of the New Law:
In general, adjustments to items of partnership income, gain, loss, deduction or credit are determined at the partnership level. However, if any tax deficiency exists, the IRS will impose and collect tax at the partnership level at the highest individual or corporate rate in effect for a reviewed year (i.e., the "imputed underpayment"). However, capital gain and qualified dividend rates may also be taken into account under certain circumstances.
Entity Level Liability and Collection:
The imputed underpayment is assessed to the partnership in the year an audit or judicial review is complete. Thus, those owners of a partnership at the time of the completion of an audit or judicial review will bear the ultimate cost of such imputed underpayment even if such owners were not partners in the year under review. In addition, the partnership is also liable for related penalties and interest for which the partnership is not allowed a deduction. Finally, while imposing tax at the entity level may be beneficial for the IRS; such adjustments may or may not be beneficial to the partners since adjustments will be determined without taking into account partner level items that may reduce or eliminate the tax associated with any adjustment.
Potential Modification to Imputed Underpayment:
Partnerships may reduce the imputed underpayment under IRS procedures yet to be fully developed if one or more partners file amended returns consistent with the audit determination and include payment with that return. Generally, the Partnership will need to provide proof to the IRS within 270 days to modify the imputed underpayment.
Election to Pass Through Liability:
Alternatively, a partnership may elect to have audit adjustments pass through to each of its owners by issuing revised Schedule K-1's to such partners. This election is required within 45 days after the date of the notice of final partnership adjustment. Thus, the obligation to pay any resulting tax is imposed upon the entity's owners (as well as filing any applicable amended returns). Obviously, this may be beneficial to the entity's owners because the owners may then use their own individual tax attributes and the revised Schedule K-1's are issued to partners who were partners during the tax year under audit. As such, the burden for any tax obligation will not fall upon new partners who may have joined a partnership subsequent to the tax year under audit.
In addition, partnerships may elect out of the new rules if such entity has less than one hundred partners and the partners consist of any person other than a partnership (e.g., individual, C and S corporations, or an estate of a deceased partner). Such an election is required each year.
The Act also eliminates the concept of a "tax matters partner" and creates a new "partnership representative." The "partnership representative" need not be a partner, as the Act only requires that the representative have a substantial presence in the U.S. The representative has the sole authority to bind the entity and its partners on matters related to the audit or litigation thereof irrespective of owners' knowledge or opinion. Due to the increased authority of the representative, it is prudent that partnerships carefully consider whom to appoint as a representative and what contractual obligations should be in place so that at a minimum the partnership representative keeps the other partners informed during an audit.
Partnership, operating, tax allocation, and other agreements that affect income tax audits of entities will need to likely be amended for items such as the following:
- Limiting the authority of the "partnership representative" by giving oversight authority to the partnership's manager, members, or committee.
- Providing that the "partnership representative" provide information to and consult with the partners before agreeing to certain positions on proposed adjustments.
- Including language that will place the economic burden of an adjustment on the partners who were owners during the audit year rather than partners who are owners during the year the audit is assessed.
- In the event of a partnership level tax payment, adding language regarding a mechanism of economic sharing of such entity level payment among partners including such things as providing that distributions may be withheld in the even of an ongoing or anticipated tax audit.
- Addressing whether certain elections will be required or optional.
- Restricting transfers of partnership interests that would preclude an opt-out election.
Buying and Selling Business Considerations:
Generally, the Act contemplates that imputed underpayments are assessed to the partnership in the year an audit or judicial review is complete. Therefore, owners in a partnership at the time of the completion of the audit or judicial review will bear the ultimate cost of such imputed underpayment even if such owners were not partners in the year under review.
Acquisitions and sales will need to be structured in light of the Act. Former and new partners will need to consider many items such as which parties will bear the costs of audits and resulting taxes imposed at the partnership level, which party will control the audits for pre-closing periods, who will be the partnership representative, and whether certain elections will be required or optional.
Owners that desire to control their own destiny with respect to partnership audits need to consider amending and adding language to their existing and new agreements that take the new Act into consideration.