On November 2, 2015, President Obama signed into law the Bipartisan Budget Act of 2015 (the “Act”) (Public Law 114-74). Among the various provisions within the Act is a change in how the IRS audits partnerships, as well as elimination of the tax matters partner. The new rules apply to partnership returns for tax years beginning on January 1, 2018. However, pursuant to procedures yet to be established by the IRS, partnerships can elect to apply the new rules to any return for a tax year that began after November 2, 2015.
These new rules are subject to clarification prior to becoming fully applicable. Evidence that the clarification process has begun is found in the March 28, 2016 IRS request for comments on implementation of a number of the partnership audit provisions. Comments were due on April 15, 2016 on electing out of the new audit rules, designation of the PR, and the push up election, in addition to other components of these new rules.
Under the new rules, audits and resulting adjustments will take place at the partnership level. Any subsequent assessment of taxes and related penalties and interest will be assessed at the entity level at the highest individual or corporate tax rate in effect for the year under audit.
Partnerships can elect to have the assessment pass directly to partners by way of a “push up” election. Where a push up election has been made, a revised K-1 is issued to those who were partners during the reviewed year. A benefit of the push up election is that underpayments can be calculated based on a partner’s individual tax rate, and offset based on the partner’s specific tax situation, rather than being taxed to the partnership at the highest marginal rate without offsets. Individual partners may also be able to deduct interest on underpayments while the partnership cannot.
Qualifying partnerships can opt out of the new rules. Upon opt out, any tax adjustments and related penalties and interest are determined at the partner level. The IRS has yet to specify the exact process by which a partnership will opt out. However, the Act limits opt out to those partnerships with 100 or fewer partners. In this context, a partner includes an individual, a C corporation, any foreign entity that would be treated as a C corporation if it were a domestic entity, an S corporation, or an estate of a deceased partner. Each individual S corporation shareholder counts towards the 100 partner limit. Opt out is not available if there is a partnership or trust among the partners.
The Act also eliminates the role of tax matters partner and replaces it with the Partnership Representative (the “PR”). The PR is not required to be a partner of the partnership but must have a substantial presence within the United States. If a partnership has not designated someone as a PR, the Act authorizes the IRS to appoint someone as the PR.
The PR is the direct liaison between a partnership and the IRS. The PR has the exclusive right to act for, represent and bind a partnership in an audit proceeding. This includes whether or not to extend the statute of limitations, contesting or settling an audit, and various Tax Court matters. Individual partners have no such rights outside of the partner’s control and authority over the PR.
Partnerships must prepare for the impact of these new rules.
Because tax adjustments and related penalties and interest can be assessed against a partnership entity, it is possible for current partners to be financially responsible for the actions of former partners. Partnership agreements and operating agreements (“Agreements”) should be amended so that those who were partners in the reviewed year indemnify the partnership and the other partners from any subsequently assessed tax, penalties and interest. Where there is no push up election or indemnification, Agreements should outline the process by which partners determine whether tax adjustments and related penalties and interest will be treated as a general expense to the partnership entity or allocated to partners.
A partnership that opts out of the new rules must remain cognizant of any incoming partners and how they may impact the partnership’s ability to opt out.
Considering the powers held by the PR, it is imperative that partnerships designate their PR as well as establishing oversight and control of the PR. While it is somewhat reasonable to believe that the IRS would appoint someone from within a partnership to the PR role, the Act provides no limitations as to who the IRS can appoint to this role.
Agreements should specify the process and limitations under which the PR is appointed and is authorized to act for the partnership. Certain situations may justify indemnification for the PR as well. The PR must be required to provide regular and timely communication to partners regarding all tax matters. Resolution of partner deadlock regarding PR actions or authority should also be incorporated in Agreements.
These rules also require consideration in the context of mergers and acquisitions. The possibility exists that a target partnership could be audited and assessed taxes and penalties after a merger or acquisition has taken place. Merger and acquisition agreements should contain indemnification provisions whereby partners for the tax year at issue remain liable for any additional taxes, interest and penalties.
Continue reading →