On November 2, 2015, President Obama signed the Bipartisan Budget Act of 2015, which made drastic changes to federal income tax audit rules applicable to partnerships. Most significantly, the new rules will allow the IRS not only to make audit determinations at the partnership level but also to assess and collect tax at the partnership level. Because tax returns are often audited years after they are filed, the effect may be to force current owners to bear the tax liability that should belong to past owners. This aspect of the rules brings the tax treatment of partnerships closer to that of corporations. Furthermore, the way in which the tax is calculated, based on an "imputed underpayment," could result in punitive assessments against partnerships even where no tax is owed to the IRS on a net basis. These new audit rules are expected to make it easier for the IRS to audit partnerships and are estimated to raise $9.3 billion over ten years.
These new rules, which replace the current TEFRA audit rules, will go into effect for partnership taxable years beginning after December 31, 2017. Joint ventures, investment funds, and other partnerships should review and amend partnership documents before that time to provide for these new rules. Partnerships should consider adding tax-related clawback provisions and indemnities, though this will be difficult for MLPs and other large investment partnerships.
Determination of imputed underpayment
An imputed underpayment (if any) is determined by netting all adjustments of income, gain, loss, and deduction, and multiplying the net adjustment by the highest rate of tax in effect for the reviewed year under section 1 or 11. Although payable by the partnership, the imputed underpayment is determined by looking at the net adjustments for each partner. This highest rate applies regardless of the rates at which the partners actually paid tax for the relevant year, which could result in a higher tax than would be due if adjustments were actually made on the partners' returns.
If the issue is not omission of income or gain but rather a misallocation of income, the new rules essentially tax the partnership on a gross basis. That is, if the partnership has correctly recognized $100 of income but misallocated it to Partner A rather than Partner B, and the IRS determines that the income should have been allocated to Partner B, the IRS would assess tax against the partnership based on the gross amount of $100, without regard to the fact that Partner A in fact overpaid tax. The reduction in income for Partner A is apparently taken into account for the year in which the IRS makes the adjustment as a reduction in non-separately stated income. Presumably, this reduction in income should be allocated to Partner A. It is not clear what would happen if Partner A is no longer a partner at the time of the adjustment. This provision gives the IRS an incentive to re-allocate income (or items of loss or deduction) because the partnership would also owe interest and penalties for the faulty allocation.
Unlike an earlier version of the legislation, the new rules do not make the partners and partnership jointly and severally liable for the imputed underpayment. However, by making the partnership liable for the tax, the new rules could require partners to economically bear tax liability with respect to years in which they were not partners.
Interest and penalties
Interest and penalties are assessed at the partnership level and based on the imputed underpayment, even if (a) the tax rate is too high and (b) the IRS is not owed tax on a net basis (i.e., there was a simple misallocation of income between two partners with similar tax situations). Under current law, the IRS has the ability to make partnership-level determinations with respect to certain penalties relating to an adjustment to a partnership item. The new provisions continue that theme but also make the partnership liable for the penalties.
Election to have partners pay underpayment
Instead of paying the imputed underpayment (or disputing the adjustment), the partnership may elect to notify each partner for the year under audit of the partner's share of any adjustment. Each such partner would then be required to take the adjustment into account in determining the partner's tax liability for the year when the partnership provides the statement. It is not clear how this election to "settle up" in the year of the IRS adjustment would work in the case of reallocations of items among partners.
Certain partnerships with 100 or fewer partners can elect out of the new provisions, but the election would not be available if any partner is itself a partnership or trust. It is not clear whether the election would apply to a partnership with a disregarded entity as a partner. The IRS has taken the position under the TEFRA audit rules that a disregarded entity partner disqualifies a partnership from the small partnership exception to TEFRA. A partnership that elects out would not be subject to audit at the partnership level. Rather, each partner would separately be subject to audit (and potential IRS whipsaw). On the other hand, the IRS would have the administrative burden of conducting several or numerous parallel audits of the partners.
The partnership must designate a representative with a significant presence in the United States. Unlike the current TEFRA audit rules, this representative need not be a partner. The partners and partnership will be bound by actions taken by the representative in the course of the audit and by any final decision in a tax proceeding with respect to the partnership.