New Partnership Audit Regime: Opt-Out, Push-Out, or Pay-Up?

• Author: Horowitz, Mitchell I.
• Position: Tax Law

On November 2, 2015, Congress passed the Bipartisan Budget Act of 2015 (BBA), (1) which enacted a new centralized audit regime (regime) that applies to all entities taxed as a partnership for taxable years starting after December 31, 2017. The most important feature of the regime is that it refocuses all audit activities on the partnership itself instead of the partners, including requiring assessments of tax deficiencies and collections at the entity level. The BBA identified several issues for which the Treasury Department and Internal Revenue Service (IRS) were to promulgate regulations to carry out the statutory objectives. This was a significant undertaking for Treasury and IRS, as the BBA flipped partnership taxation from a "flow-thru" construct to one in which the partnership would be primarily liable for any additional income tax due after audit. The congressional goal was to reduce the administrative burdens placed on IRS for audits of partnerships, and move that burden to the partnerships themselves. (2)

After passage of the BBA, many comments on the new law were submitted, (3) including by the Section of Taxation of the American Bar Association (4) and the American Institute of CPAs. (5) Treasury and IRS maintained an open dialogue with these and other adviser groups as the comments were being submitted and requested comments on specific topics with which they were struggling in the drafting process. (6) The comments pointed out many flaws in the BBA language, so much so that on December 6, 2016, Congress introduced the Tax Technical Corrections Act of 2016, (7) which addressed a number of those problems, but that legislation did not pass. (8) On January 18, 2017, Treasury finally issued 277 pages of proposed regulations and commentary on the new regime (regs), (9) but their publication in the Federal Register was postponed by the Trump regulatory freeze and the regs were not reissued until June 14, 2017 (with minimal changes).

Due to space constraints, this article deals with only the "opt-out" and "push-out" elections available under the regs and a variation of the "pay-up" default rule that applies when a partnership does not make one of those two elections. To learn more about the other significant changes made by the BBA and regs not covered in this article, there are many other articles and resources. (10) Practitioners need to review these other resources to fully appreciate the critical role of the "partnership representative" under the new regime, how imputed underpayments and proposed assessments can be modified, making administrative adjustment requests, and how operating and partnership agreements should expressly address these issues and the elections described in this article.

Opt-Out Election

Because the partnership is now primarily liable for tax deficiencies under the new law, this historical burden has been effectively transferred from reviewed year partners (11) to audit year (12) partners. When the partners and their profit and loss percentages are the same, this may not be an unwelcome result. However, that will often not be the case. If a partnership can opt-out of the regime altogether, any audits and assessments involving partner ship items will be made at the partner level instead of the partnership level, such that those burdens would be "retained" by the reviewed year partners as under current law.

This approach is intuitively fair and preserves the historical "pass thru" consequences of matching owners with the operations that occurred while they were owners. Also, it may be a natural reaction to the regime's complexity and lack of reliable guidance at the present time. However, many factors need to be considered when choosing to opt-out rather than letting the partnership simply "pay-up" the imputed underpayment. For example, some partners may not want IRS reviewing partner-level items unrelated to partnership operations. Some situations may be more efficiently or better addressed by having the partnership items resolved under the regime, such as when ownership changes are infrequent or when the reviewed year partners and audit year partners are otherwise the same (as in closely held or family-owned businesses). There may also be cases in which the partners want all tax matters involving the partnership to be resolved at the same time and in a more predictable and consistent manner. If the partnership were to opt-out, IRS could still audit the partnership, but the partnership could not extend the statute of limitations for assessment for flow-thru items for the partners. Rather, each partner's period for assessment and refunds for partnership items would correspond to the partner's individual limitation period for other audit items and IRS would need to enter into a separate agreement to extend the period with each partner.

Likewise, the partnership could not settle partnership items on behalf of...