Partnership audit rules for the next decade.

• Author: Williamson, Donald T.
• Position: Cover story

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As part of its budget agreement enacted last November, Congress replaced the rules governing the audit procedures for partnerships established by the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), (1) as well as the special rules for electing large partnerships, with a new audit regime for all partnerships under which adjustments are made at the partnership level, and the tax due as a result of the adjustments is collected from the partnership. (2) The discussion below analyzes these new rules and describes important elections the partnership may make, under certain conditions, to opt out of the new rules altogether or to allocate the income attributable to a partnership adjustment to persons who were partners for the year to which the adjustment relates.

Not effective until partnership tax years beginning in 2018, the new audit procedures are unlikely to be put into practice before 2020, for returns filed in 2019. However, partnerships may elect to adopt the rules for any tax year beginning after the date of the statute's enactment, Nov. 2, 2015, so professionals need to understand these rules now. In any case, due diligence calls for partners and their advisers to immediately review their partnership agreements to determine what should be changed now to take into account the new rules when they become generally effective.

Reasons for Change

The TEFRA rules for auditing partnerships were enacted in 1982 to facilitate IRS audits, including those of mass-marketed tax shelter partnerships, which after 1986 largely disappeared as a result of the passive activity loss rules. However, over the last two decades, growth in the number and size of large partnerships has created new challenges to the IRS's ability to audit these entities. In 1997, to address the complexity of the TEFRA rules, Congress created an elective regime allowing partnerships with 100 or more partners to pay tax, interest, and penalties on adjustments to the partnership return. (3) But by 2013, only 91 of the 10,948 partnerships with more than 100 partners had elected these rules. (4)

In July 2014, the U.S. Government Accountability Office (GAO) reported that the number of large partnerships (defined as those with at least $100 million in assets and at least 100 direct or indirect partners) more than tripled from 2002 to 2011, but only 0.8% of such entities were audited by the IRS, compared with 27.1% of comparable large corporations. (5) The GAO noted that under the TEFRA rules, passing partnership adjustments through to the partners was a costly and inefficient process, particularly in the case of multitiered structures. (6)

In response to these concerns, Reps. Jim Renacci, R-Ohio, and Ron Kind, D-Wis., both members of the House Ways and Means Committee, introduced H.R. 2821, the Partnership Audit Simplification Act of 2015. This bill, with substantial modification, became the basis of the new partnership audit rules adopted by the Budget Act last November. But because the estimated additional revenue from the changes was essential to the passage of the overall Budget Act, the public had little opportunity to comment on the proposal. (7) Fortunately, however, the new rules do not become generally effective until after 2017, (8) allowing time for issues to be identified and for the IRS, Treasury, and, if necessary, Congress, to provide clarification and guidance. (9)

A New Approach

TEFRA addressed a problem of applying partnership adjustments to multiple partners in separate proceedings by specifying that the tax treatment of "partnership items," including underpayments of tax and penalties arising from them, is determined at the partnership level, in a unified proceeding binding upon all partners. (10) Fresh controversies erupted, however, over defining and clarifying which items were partnership items and which were partner-level items.

The Budget Act dispensed with the partnership-item criterion in favor of determining any adjustment to items of income, gain, loss, deduction, or credit of all partnerships at the partnership level, with the partnership, rather than partners, generally liable for any resulting imputed underpayment. However, in certain cases partnerships will be able to elect out of the new rules.

Electing Out of the New Rules

While the new audit and adjustment rules apply to all partnerships for tax years after 2017, certain partnerships will be able to elect out of the regime. Upon electing out for a tax year, the partnership is subject to the general rules for the assessment and collection of tax deficiencies. Therefore, any adjustment to partnership taxable income will flow through to the partners with the assessment of tax, and the statute of limitation for the assessment will be determined at the partner level, perhaps resulting in inconsistent treatment among the partners. Similarly, partners will make any extension of a statute of limitation, settlement agreement, notice of deficiency, petition to the Tax Court, or suit for a refund individually on a partner-by-partner basis.

Since this is an annual election, a partnership may elect out in some years and not in other years. A partnership may elect out, under procedures to be issued, for a year if:

* The partnership is required to issue no more than 100 Schedules K-1, Partners Share of Income, Deductions, Credits, etc., to its partners; (11)

* Each partner is an individual, an estate of a deceased partner, an S corporation, a C corporation, or a foreign entity that would be treated as a C corporation if it were domestic; (12)

* An election is filed with a timely filed return identifying the names and identification numbers of the partners; (13) and

* The partnership notifies each partner of the election. (14)

Thus, a partnership that has as a partner another partnership or a trust, including a grantor trust, may not elect out. Furthermore, any partnership with a tax-exempt organization as a partner will need to determine whether the entity is a C corporation or trust for purposes of eligibility to elect out.

Where an S corporation is a partner, the names and taxpayer identification numbers of the S corporation's shareholders must be included with the election statement, and the Schedules K-l, Shareholder's Share of Income, Deductions, Credits, etc., of the S corporation's shareholders (as well as the S corporation itself) count in measuring the 100-partner limit. (15) Most important, the IRS is authorized to issue similar rules allowing partnerships to elect out regardless of the type of entities owning a partnership interest, as long as the total number of Schedules K-l required to be issued by the partnership and its partners do not exceed 100 and the partnership discloses the identities of indirect partners. (16)

Example 1: A partnership, L, has 50 partners, 49 of whom are individuals and one of which is another partnership, U. U has 50 partners who are all individuals. Under the statute, L may not elect out. However, the statute authorizes regulations similar to the rules for S corporations, and such regulations could provide that if the sum of L's direct and indirect partners, including U, does not exceed 100, L may elect out of the new audit rules. (17)

An issue that regulations will have to clarify is the treatment of multiple Schedules K-l issued to the same partner, representing different classes of interest. Thus, where an individual receives a Schedule K-l for his or her general partnership interest and a separate Schedule K-l for his or her limited partnership interest in the same partnership, it is unknown whether both schedules will count toward the 100-partner limit. Also, a transfer of a partnership interest will create two Schedules K-l with respect to that interest if the transferee partner did not already hold an interest in the partnership at the time of transfer. (18)

For determining whether a foreign entity is a C corporation for purposes of the election out, the regulations defining...