Passed in late 2015, the Bipartisan Budget Act (BBA) completely overhauled the rules relating to partnership tax audits. Set to take effect on January 1, 2018, the BBA partnership audit regime represents a significant shift in how the IRS will audit partnerships.
Under prior rules, audits were conducted at the partnership level, partnership adjustments were paid at the partner level, and partners were granted information and participation rights in the audit process. These rules have been in place since 1982 and will be inapplicable to tax years beginning on or after January 1, 2018.
Under the BBA partnership audit regime, audits will occur at the partnership level; however, unlike prior rules, all adjustments will be calculated and paid at the partnership level in the year of the assessment (and not the tax year under review), with certain exceptions applying, as discussed below. Additionally, unlike the prior audit regime, partners are not granted information or participation rights with respect to a partnership audit. The intention of the new partnership audit regime is to facilitate efficient and revenue productive audits, especially with respect to tiered partnership structures.
Opting out of new rules – limited applicability
Some partnerships can elect out of the BBA partnership audit regime. In order to opt out of the new rules a partnership must have 100 or fewer partners. Additionally, the partners of a partnership must either be (i) individuals, (ii) S corporations, (iii) C corporations, or (iv) an estate of a deceased partner. A partnership with a trust or a partnership as a partner would not qualify for an opt out. If an eligible partnership opts out, the partners can only be audited separately.
Pushing out tax adjustments to reviewed year partners
Regardless of partnership composition, any partnership may make an election to “push out” any final partnership adjustment to the partners of a reviewed year if such an election is made within 45 days of the issuance of a final partnership adjustment. A push out election prevents current partners from bearing the economic burden of paying for the tax liabilities of former partners or partners with reduced interests in the affected partnership items.
Revisions to partnership agreements
Planning for the new partnership audit rules can be complex, and requires more than an additional paragraph to existing partnership agreements. Any revisions to partnership agreements should carefully consider how to best deal with changes in partner composition, as current partners may be left with the economic burden of paying for the tax liabilities of former partners. Although not exhaustive, partners should consider the following:
- Amend partnership agreements to properly reference and appoint a “partnership representative.” The partnership representative replaces the “tax matter partners,” but with certain notable changes. The partnership representative has exclusive authority to negotiate with the IRS, and need not be a partner. For example, an accounting or law firm may be appointed as partnership representative. Contractually limiting the authority of a partnership representative may also be a prudent consideration.
- Amend partnership agreements to address whether or not a 45 day election is required. In a commercial setting, partners would generally want to ensure that former partners remain liable for their fair share of tax adjustments, and thus would want to mandate a 45 day election. However, in the family context, families may not want to mandate a 45 day election.
- Incorporate indemnification agreements or claw-back provisions to require former partners to reimburse a partnership for their share of tax adjustments. In the family context, a family investment partnership may want to enter into indemnification agreements with third party partners, such as key employees of the family enterprise. Alternatively, if a partnership has different classes, a partnership may want to consider implementing claw-back language into the partnership agreement, so as to require some, but perhaps not all, classes to indemnify the partnership with respect to tax adjustments.
Partnerships and their partners should carefully consider how to navigate the new partnership audit regime, taking into account the facts and circumstances of each partnership. In light of the new regime's effective date of January 1, 2018, partnerships should immediately consider how to navigate the new rules, especially with respect to appointment of partnership representatives and departing partner liability. Lastly, investors in joint ventures taxed as partnerships should inquire as to how the joint venture will deal with the BBA rules.