New Rules on Audit Procedures Change Partnership Tax LandscapeFebruary 2016
The Bipartisan Budget Act of 2015 (the "BBA"), signed into law on November 2, 2015, substantially changes partnership audit rules. The BBA replaces the old audit process in which the Internal Revenue Service (the "IRS") adjusts items at the partnership level, but seeks to collect from individual partners, with a new process that potentially imposes an entity level tax with respect to adjustments arising from an IRS audit. The partnership level assessment makes it simpler for the IRS to undertake partnership audits and is expected to increase the number of those audits.
The new audit procedures apply to all partnerships unless they are eligible to, and in fact do, elect out as described below. With the new process, the IRS conducts audits, makes resulting adjustments and assesses any tax liability at the partnership level. The liability is, in the first instance, borne by the partnership and, indirectly, by the partners at the time the IRS makes the adjustment (the "Adjustment Year") even if they were not partners during the year to which the adjustment relates (the "Reviewed Year").
Opt-Out and Push-Out Elections
Certain partnerships with fewer than 100 partners can elect out of the new regime (the "Opt-Out Election"), in which case the partnership and the partners would be audited under the general rules applicable to individual taxpayers (i.e., each partner is audited individually). However, partnerships that have upper-tier partnerships, trusts or tax-exempt entities as partners are not eligible to opt out of the new regime. The Opt-Out Election is made on a year-by-year basis, and is made effective by the partnership, including such election with its tax return for each year it chooses to opt out.
Even if a partnership cannot or does not elect to opt out of the new rules, it can elect, within 45 days of a notice of final adjustment, to "push out" the tax assessment (the "Push-Out Election") to the Reviewed Year partners. These Reviewed Year partners are required to take the adjustment into account with their tax returns in the Adjustment Year.
The BBA replaces the "tax matters partner" with an expanded "partnership representative" who (while not required to be a partner) has authority to act on behalf of the partnership in an audit and binds the partnership and its partners by his or her actions. Partners do not retain rights to notice of, and participation in, administrative proceedings and will be unable to challenge IRS determinations separately from the partnership.
Planning for the New Audit Procedures
The new audit procedures will be in effect for partnership tax years beginning after December 31, 2017. Partnerships and partners should begin planning for the implementation of these rules early, as the new regime is likely to have a number of immediate consequences.
First, LLC operating agreements and partnership agreements should be revised to reflect the new rules, and to set forth the parties' decisions as to the various elections available to them. Second, investors must be aware that the new rules could result in an entity-level federal income tax exposure for partnerships. Accordingly, due diligence concerns and indemnity obligations that historically were relevant to corporations should now be considered in connection with partnerships.
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© 2016 Herrick, Feinstein LLP. This alert is published by Herrick, Feinstein LLP for informational purposes only. Nothing contained herein is intended to serve as legal advice or counsel or as an opinion of the firm.