BRIEFING
CHANGE IN U.S. PARTNERSHIP TAX
RULES WILL REQUIRE CHANGES TO
PARTNERSHIP AGREEMENTS
NOVEMBER 2015
● PROVISIONS IN THE
BIPARTISAN BUDGET ACT
OF 2015 CHANGE THE
RULE FOR TAX AUDITS AND
CONTESTS OF
PARTNERSHIPS IN THE U.S.
● THOSE DRAFTING NEW OR
RELYING UPON EXISTING
PARTNERSHIP AGREEMENTS
WOULD BE WELL-ADVISED
TO CONSULT A U.S. TAX
PROFESSIONAL REGARDING
THE CHANGE IN LAW.
Provisions included in the Bipartisan Budget Act of 2015 (the “Act”) — signed
November 2, 2015 — change the rules for tax audits and contests of partnerships1
in the U.S.
“THESE CHANGES WILL
IMPACT CURRENT TAX
PLANNING FOR
PARTNERSHIPS AND
LLCS…”
These changes will impact current tax planning for partnerships and LLCs that file
U.S. tax returns — including non-U.S. partnerships — and may also require changes
to their governing documents. Those who are drafting a partnership agreement with
U.S. tax provisions, or who are relying on a previously-drafted agreement, would be
well-advised to consult a U.S. tax professional regarding the change in law.
PRIOR LAW
The United States does not tax entities that are classified as partnerships. Instead, an
entity treated as a partnership for U.S. tax purposes files an information return on
Form 1065 and sends Schedule K-1s allocating income, losses and other tax items
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1
A “partnership” for this purpose means any entity that is classified as a partnership for U.S. tax purposes. This can include limited liability companies (“LLCs”), and includes
non-U.S. entities with more than one partner/owner/member that have elected to be classified as partnerships for U.S. tax purposes.
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of the partnership as a whole to the individual partners. The partners themselves
then report the income and other tax items and pay any resulting income tax.
Until 1982, this meant that partnership income or loss was reviewed by the IRS as
part of a review of the tax return of each partner. This proved very cumbersome and
often yielded inconsistent results — for example, some partners might be audited
and others not. In 1982, the U.S. created a centralized partnership audit system
known as “TEFRA.”2 Under TEFRA, the basic rules are:
● The tax treatment of all “partnership items” must be determined at the partnership
level.3
● The partnership or LLC designates a “tax matters partner” who must be a partner
or member of the entity to represent it in TEFRA proceedings. The tax matters
partner generally has the right to extend the statute of limitations, file for refunds
and settle proposed adjustments, and is the person the IRS will normally deal with
during the audit process.
● Other partners or members with a 1% or greater profits interest in the entity, or
any interest if there are 100 or fewer partners or members (“notice partners”),
have the right to receive notices of proceedings and adjustments directly from the
IRS and to initiate a contest (if the tax matters partner does not do so) and to
participate in any contest proceeding. The tax matters partner generally may not
bind a notice partner to a settlement agreement.
● The TEFRA rules provide a minimum statute of limitations of three years that
applies to the partnership return (i.e., the statute of limitations for partnership
items in a taxable year cannot be less than three years after the filing of the
partnership return or the due date for the return, whichever is later) but the “true”
statute of limitations is either this period or the period determined by reference to
the partner’s tax return, whichever is the longer.
“… THE NEW AUDIT RULES
ALLOW THE IRS TO DEAL
EXCLUSIVELY WITH A
SINGLE REPRESENTATIVE
OF THE PARTNERSHIP…”
NEW PARTNERSHIP AUDIT RULES
The new partnership audit rules apply to all entities treated as partnerships for U.S.
tax purposes (mostly partnerships and LLCs) that are required to file U.S. partnership
tax returns. A non-U.S. partnership generally is required to file U.S. tax returns if it is
engaged in a U.S. trade or business, or earns U.S.-source income and has U.S.
partners.
At a very general level, the new audit rules allow the IRS to deal exclusively with a
single representative of the partnership, impose the burden of paying the resulting
tax on the partnership, and allow the partnership, in turn, to push the liability on to
its partners or members.
2
The Tax Equity and Fiscal Responsibility Act of 1982.
In certain circumstances, partnership items can be converted into non-partnership items, the effect of which is that a partner can deal with the IRS directly, rather than through the
partnership.
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U.S. PARTNERSHIP TAX: CHANGE IN PARTNERSHIP AUDIT RULES
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Partnership Representative
The new partnership audit rules replace the concept of a “tax matters partner” with
the concept of a “partnership representative.” There are several important
differences between a tax matters partner and the new partnership representative.
● A partnership representative does not need to be a partner. The only requirement
is that the representative has a substantial presence in the United States.
● The Act eliminates the concept of a “notice partner.” As a result, the partnership
representative has the exclusive right to take action with respect to a partnership
audit, which may include litigating or settling IRS claims. This may create perverse
incentives, some of which are discussed below.
“THE NEW PARTNERSHIP
AUDIT RULES IMPOSE THE
LIABILITY FOR
ADJUSTMENTS TO TAX ON
THE PARTNERSHIP OR LLC,
RATHER THAN ITS
PARTNERS OR MEMBERS.”
Partnership-Level Tax
The new partnership audit rules impose the liability for adjustments to tax on the
partnership or LLC, rather than its partners or members.
● The imputed underpayment is generally calculated by netting all audit
adjustments, and multiplying the net underreported income by the highest
marginal U.S. federal income tax rate (currently 39.6%), regardless of the actual
tax rates applicable to the partners.
● The payment is made for the tax year of the adjustment, not the tax year under
review. For example, if the IRS determines in 2021 that a partnership’s 2018 tax
return resulted in an underpayment, the partnership would owe tax on its 2021
tax return.
● The partnership also owes interest, and possibly penalties, on the deemed
underpayment. This interest is not deductible (in contrast to the usual rule for
interest).
● There is no netting of benefits and costs to partners. For example, if a partnership
allocates $100 of income 50/50 between Partners A and B, and the IRS
determines on audit that the full $100 should have been allocated to Partner A,
the partnership owes tax on the additional $50 allocated to Partner A, with no
offset for the $50 of income removed from Partner B’s allocation.
“…IF ONE OF THE
PARTNERS OR MEMBERS IS
ITSELF A PARTNERSHIP, THE
ENTITY CANNOT ELECT
OUT.”
● If the partnership ceases to exist prior to the assessment, the historic partners are
liable for the imputed underpayment (pursuant to regulations to be drafted).
Otherwise (and in the absence of a push-up election as described below), there is
no joint and several liability for an imputed underpayment. The liability is on the
partnership alone.
Electing Out
There are two ways that a partnership may elect not to pay the tax:
● A partnership may elect out of these rules entirely by so noting on its partnership
return if (i) it has 100 or fewer partners, and (ii) none of its partners are
partnerships or trusts. This means that if one of the partners or members is itself
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a partnership, the entity cannot elect out.
– If a partnership elects out, the IRS may still audit the partners, but will generally
be unable to perform a unified audit of the entire partnership. The election to
opt out is made for each taxable year, so a partnership may be eligible to
make the election in one year but not another.
● If on audit of a partnership that has not elected out, the IRS assesses the
partnership, the partnership may avoid paying the adjustment by instead issuing
revised Schedule K-1s (or similar forms) to its partners, effectively passing the tax
obligation up to the partners. We refer to this as a “push-up election.”
Other Features of the New Audit Rules
“THE NEW RULES HAVE
SOME VERY STRICT
DEADLINES.”
● Statute of Limitations
The Act provides a statute of limitations for IRS audits of a partnership return,
which expires three years after the return is filed (or the return due date, if later),
with certain exceptions. This is in stark contrast to the statute of limitations under
TEFRA, which is complex, but generally provides that the statute of limitations is at
least three years, but may extend further. For example, under TEFRA, if a
partnership files a timely return, but one of the partners never files a return for the
relevant year, the IRS could assess the tax on partnership income long after three
years from filing. Under the new partnership audit rules, the IRS cannot assess the
tax on partnership income on the partner who has not filed a return once the
partnership-level statute of limitations period has expired.
● Deadlines
The new rules have some very strict deadlines. Most importantly, the push-up
election must be made within 45 days of receipt of a final partnership adjustment
from the IRS.
“WHEN THE NEW
PARTNERSHIP AUDIT RULES
START APPLYING
AUTOMATICALLY IN A FEW
YEARS, THE EXISTING TAX
AUDIT ARRANGEMENTS IN
THESE AGREEMENTS…
WILL NOT WORK.”
● Effective Date
The rules are scheduled to go into effect for partnership taxable years beginning
in 2018. Because a partnership’s 2018 return will be filed only in 2019, and it
typically takes at least a calendar year to begin audit proceedings, the new rules
likely will not be applied until 2020 at the earliest. However, a partnership may
elect to have the new partnership audit rules apply as early as its 2016 tax return.
WHAT NEEDS TO BE CONSIDERED NOW
Most U.S. partnership and LLC agreements contain rules for dealing with the TEFRA
audits: the agreement provides for a tax matters partner and divides responsibility
and rights among the partners for how the tax matters partner can act and how any
TEFRA audit and contest may be conducted. When the new partnership audit rules
start applying automatically in a few years, the existing tax audit arrangements in
these agreements designed for the TEFRA audit will not work.
Partnerships and LLCs should be revising their governing agreement well before the
effective date. The most important questions in drafting the agreement are:
U.S. PARTNERSHIP TAX: CHANGE IN PARTNERSHIP AUDIT RULES
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1. whether to elect out (if possible) or require the push-up election if electing out is
not possible;
2. how much power to give the partnership representative in making decisions on
behalf of the partnership; and
3. how the agreement’s default provisions work together if the parties cannot come
to a resolution regarding tax decisions.
“TREATING THE IMPUTED
UNDERPAYMENT AS A
GENERAL PARTNERSHIP
EXPENSE HAS THE VIRTUE
OF SIMPLICITY, BUT IT
ALSO MAY RESULT IN AN
UNJUST ENRICHMENT TO
A PARTNER (AND AN
UNFAIR BURDEN TO THE
OTHER PARTNERS)…”
Some issues relating to these questions are noted below. These are illustrations
of just some of the decisions that the partnership or LLC will need to make about
how to deal with IRS audits under the new rules.
Election to Transfer Tax Liability to the Partners
One of the important decisions to be made is whether to elect out of the rules for
partnerships that qualify. Partnerships that do not qualify (or choose not) to elect out
need to decide whether to make the “push-up election” mandatory. This decision
may be made by the partnership each time the IRS actually makes an adjustment but
it may be better to decide how and whether that election will be made in the
governing agreement.
The major economic advantage to pushing the imputed underpayment up to the
partners is that the partners will be able to calculate the imputed underpayment
based on their actual tax rates—and offset any increase with any other tax benefits
that may be applicable—rather than a tax at the highest marginal rate with no
offsets. In addition, interest on imputed underpayments paid by the partners may be
deductible as a business expense, whereas interest paid by the partnership is not
deductible. Finally, pushing the imputed underpayment up to the partners means
that the partnership does not need to consider how to allocate the imputed
underpayment.
In some instances, having the partnership pay the adjustment itself may be simpler,
especially if there are many partners, all of whom would need to calculate the tax on
the portion of the imputed underpayment attributable to them. If the partnership or
LLC may pay the adjustment itself, the partnership or LLC agreement needs to
specify the effect of that payment. The parties need to decide whether the payment of
these taxes and interest (and any penalties) should be treated as just a general
partnership expense like any other business operating expense, or should be
allocated to the partners who would have borne the burden of the tax if it had been
pushed up. Treating the imputed underpayment as a general partnership expense
has the virtue of simplicity, but it also may result in an unjust enrichment to a partner
(and an unfair burden to the other partners), particularly if the tax adjustment relates
to how income is allocated among partners rather than to how much income the
partnership earned.
Identity of Partnership Representative
Since the Act no longer contains the concept of a “notice partner,” the only parties
that will receive notice from the IRS are the partnership representative and the
partnership itself. There may be advantages, therefore, to having the partnership
representative not be an individual but rather a company or institution that passes
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along notices and continues to act despite illness, incapacity or death of a particular
individual.
“THE CHOICE OF WHICH
PARTNER OR OTHER
PERSON WILL BE THE
PARTNERSHIP
REPRESENTATIVE IS AN
IMPORTANT ONE”
“THE PARTIES MAY WISH
TO LIMIT THE AUTHORITY
OF THE PARTNERSHIP
REPRESENTATIVE TO TAKE
ACTION WITHOUT THE
OTHER PARTNERS’
CONSENT... UNLIKE IN
THE TEFRA RULES, NO
OTHER PARTNER CAN
INDEPENDENTLY BRING
THE MATTER INTO
COURT.”
The choice of which partner or other person will be the partnership representative is
an important one, and should be discussed by the parties. The parties may also
need to consider the degree to which the partnership representative needs to be
shielded from liability for actions it takes as a partnership representative.
Partnership Representative—Control of Contests
The partnership representative has the sole authority to act for the partnership in an
audit or litigation proceeding, including extending the statute of limitations,
contesting or settling an audit proceeding, or litigating a claim in Tax Court. The
parties may wish to limit the authority of the partnership representative to take action
without the other partners’ consent. For example, the partnership or LLC agreement
may provide that all partners (or a majority or supermajority) must consent to any
action that may materially affect them. Unfortunately, the failure of the partnership
representative to act can also adversely affect partners. For example, the only way to
contest a partnership adjustment by the IRS is for the partner representative to
commence a lawsuit — unlike in the TEFRA rules, no other partner can
independently bring the matter into court. Nor does any other partner have the right
to be heard by the IRS or the Tax Court.
For this reason, in order to provide the other partners with contest rights, the
governing agreement has to provide a mechanism not just for preventing the
partnership representative from acting adversely to the other parties, but also for
actually determining the actions the partnership representative must take.
The agreement could give sole discretion to the partnership representative.
Alternatively, the agreement may provide that all decisions of the partnership
representative (whether actions or omissions) shall be dictated by a board or other
governing body, with specific provisions to address a deadlock. The agreement can
also set certain default rules (such as whether the push-up election will be made). In
some situations, where the impact of an audit may fall disproportionately on some of
the partners, the agreement may permit the most affected partners to instruct the
partnership representative in return for those partners holding the non-instructing
partners harmless.
CONCLUSION
There are still many parts of the legislation that are unclear and regarding which the
IRS has yet to issue rules and guidance. Further analysis and changes to agreements
may be required once this guidance is released. Nevertheless, these new rules are
significant changes with far-reaching implications for partnership documentation,
and firms would be well-advised to begin their planning now.
U.S. PARTNERSHIP TAX: CHANGE IN PARTNERSHIP AUDIT RULES
FOR MORE INFORMATION
Should you like to discuss any of the matters raised in this Briefing,
please speak with one of the authors below or your regular contact
at Watson Farley & Williams.
DANIEL PILARSKI
Partner
New York
STEPHEN MILLMAN
Partner
New York
+1 212 922 2234
dpilarski@wfw.com
+1 212 922 2205
smillman@wfw.com
Publication code number: 57173083v1© Watson Farley & Williams 2015
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