Practical implications of new partnership audit rules.

AuthorHauswirth, Mike
PositionASK THE EXPERTS

The Experts: Michael Hauswirth, Todd McArthur, Adam Feuerstein

Ignore the new partnership audit rules at your own peril. Absent an election of earlier application, they take effect for tax years beginning in 2018. Under the new rules, the Internal Revenue Service (IRS) generally will collect tax at the partnership level on adjusted partnership items at the highest corporate or individual rate in effect for the audit year. This tax will often be the "wrong" amount and will often be borne by the "wrong" partners. The statute offers partners limited ways to right these wrongs (or possibly opt out entirely), but partners need to understand these exceptions well before an audit--even before acquiring an interest in a partnership--to avoid the potential pitfalls of the new rules.

Question: What issues should be considered in response to the new partnership rules?

Answer: The partnership audit and adjustment rules enacted as part of the Bipartisan Budget Act of 2015 and amended by the Protecting Americans from Tax Hikes Act of 2015 (the "BBA audit rules") revolutionize the manner in which partnerships will be audited and related taxes will be assessed and collected for tax years generally beginning after December 31, 2017.

Beginning in 2018 (except with respect to partnerships electing earlier application), the TEFRA (Tax Equity and Fiscal Responsibility Act of 1982) partnership audit rules are repealed. Partnership audits and the assessment and collection of related taxes will be centralized at the partnership level, and partners will have no statutory right, as they generally do under the TEFRA partnership rules, to receive notice of, or to participate in, any partnership audit, appeal, or judicial review.

Any tax assessed will be collected at the partnership level and borne indirectly by the persons who are partners during the year of the partnership adjustment (not the year under review), unless the partnership is able to "push out" the adjusted partnership items to the persons who were partners in the year under examination (the "push-out election"). A decision to pay tax at the partnership level or to push out adjusted partnership items can materially affect the total amount of the tax and which partners bear the burden of the additional tax liability.

BBA changes

The BBA's significant changes to partnership audit and adjustment procedures will affect how partnerships and partners assess and allocate the risk of uncertain partnership tax positions. The BBA audit rules were enacted to streamline IRS audits of large and tiered partnerships and to reduce the IRS' administrative burden with respect to assessing and collecting underpayments determined as a result of partnership audits. These factors and others will likely result in an increase in partnership audit activity as the rules are phased in. (1)

Complicating matters further are numerous unanswered questions that will have to be resolved by administrative guidance or statutory changes. (2) Well before 2018, partnerships, partners, future partnership representatives, and prudent advisors will want to monitor those developments and begin to consider the impact of the BBA audit rules on the terms of partnership agreements and the due diligence and negotiation strategies of all parties involved.

Elevated Role of Single Person: The Partnership Representative

Every partnership subject to the BBA audit rules will have a "partnership representative." Any person (even a non-partner) with a "substantial presence in the United States" may be the partnership representative. If a partnership fails to designate its partnership representative, the IRS is empowered to do so.

The partnership representative has the sole and exclusive authority to act on behalf of the partnership and to bind all partners with respect to partnership matters subject to the BBA audit rules. This authority includes representing the partnership during an audit, negotiating and agreeing (or disagreeing) to settle with the IRS, and seeking judicial review of an IRS adjustment. The BBA audit rules, unlike the TEFRA rules, do not provide partners with any rights to be notified at key stages during a partnership audit or to participate in the audit, appeal, or later judicial review.

Choices Under BBA Audit Rules

How the BBA audit rules will affect a partnership and its partners will depend, in large part, on choices the partnership, the partnership representative, and the partners make or fail to make. Choosing not to address the BBA audit rules is in fact a choice to apply the default rule to adjusted items. This choice could lead, for example, to partnership-level taxation at the highest effective tax rate without reduction. The choices presented by the rules include: (1) electing into the BBA audit rules for tax years beginning after November 2, 2015, (2) electing out of the BBA audit rules if the partnership is eligible, (3) paying tax on the adjusted items at the partnership level (i.e., the default rule), (4) reducing the tax owed under the default rule by providing information about the partners' tax attributes to the IRS, (5) reducing the tax owed under the default rule by causing affected partners to amend their own tax returns, and (6) avoiding the default rule by electing to...

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