Stuart J. Frentz and Bruce P. Ely.
The Door in the Dark
In going from room to room in the dark I reached out blindly to save my face But neglected, however lightly, to lace My fingers and close my arms in an arc.
A slim door got in past my guard, And hit me a blow in the head so hard I had my native simile jarred.
So people and things don’t pair any more With what they used to pair with before.
Alabama lawyers who are trying to understand the new partnership audit procedures scheduled to be effective after 2017 should identify with Robert Frost. The statutes rushed into enactment late last year as part of the Bipartisan Budget Act of 20151 leave many questions unanswered, with several gaping holes to be filled with guidance from the Treasury Department and the IRS. And opportunities for confusion will multiply as Alabama and other states develop their own separate responses to the federal changes.2 The challenges posed for those of us drafting partnership agreements a nd related ownership transfer documents in the absence of guidance are a bit like trying to traverse a furniture-filled room in pitch darkness.
In this article, we’ll first take a look at what we do know about the new audit procedures based primarily on the statutes enacted and amended late last year and the joint committee’s Bluebook, which is as close as we get to legislative history. Then we’ll list some of the important things we do not know, and will not know until regulations and other procedural guidance trickle out of Washington.3 Finally, we’ll offer a few suggestions for what practitioners might consider doing to avoid figuratively smacking their heads into doors in the dark or tripping over furniture with regard to drafting partnership or operating agreements while waiting for the Treasury and the IRS, and perhaps Congress, to start turning on the lights.
Some Things We Know (or Think We Know) Until Things Change4
The current TEFRA audit5 are repealed prospectively, and the new rules will apply to tax years beginning after 2017–which, as of the date of this publication, is only a little over a year away. Partnerships can elect to opt in under the new rules early, although there are not likely to be many takers.6
Congress projected the new procedures to generate more than $9.3 billion in new revenue over a 10-year period.7 Many states are considering adopting all or part of these procedures for their own income tax codes and to enhance their budgets. Arizona has already enacted partial conforming legislation.8
There are a couple of defined terms we need to keep in mind. “Reviewed Year” means the tax year of the partnership under audit, and “Adjustment Year” means the year in which partnership return adjustments are finally determined.9
The new default rule under the Budget Act requires the IRS to assess the partnership on the “imputed underpayment” if filing errors are detected during an audit. The assessment is made in the Adjustment Year, so the financial burden of a payment by the partnership will fall on the partners in the Adjustment Year, even if some or all of them were not partners in the Reviewed Year. Law firms that operate as partnerships, especially those with a large number of partners, should consider how these rules will apply to your own partners and partnership.
The partnership’s imputed underpayment is computed by netting all adjustments as finally determined and multiplying that by the highest rate of tax applicable to individuals or corporations–i.e., 39.6 percent based on 2016 rates. In an especially taxpayer-unfriendly twist, adjustments that reallocate items from one partner to another (e.g., a disregarded special allocation of interest expense or gain) are not netted; the portions of the adjustment that increase items of loss or deduction or decrease items of income or gain are disregarded in determining the partnership’s imputed underpayment.So, for example, if a partnership is found to have allocated to partner A $100,000 of income that should have been allocated to partner B in the Reviewed Year, the partnership would have a $39,600 imputed underpayment in the Adjustment Year, even if A or B or both have departed and are no longer partners in that year.
If the partnership can show that an item of adjustment is allocable to a tax-exempt partner or to a partner that would be taxable at a lower rate (i.e., capital gains rate for individuals or a C corporation taxable at 35 percent), the partnership’s imputed underpayment can be reduced accordingly.11 An imputed underpayment can also be reduced to the extent that partners for the reviewed year file amended returns to reflect their shares of the audit adjustments and pay the additional taxes due.
There will be no role for a “tax matters partner” or “tax matters member” for years after 2017. Instead, the new and greatly empowered “partnership representative” (“PR”) will be the sole contact person for the IRS auditor and will be authorized under the law to make all decisions regarding how to handle the audit, whether to appeal the assessment, settle or litigate, and whether the partnership will “push out” the assessment to the former partners or pay the assessment itself. The partnership and all its partners will be bound by actions taken by the PR in connection with partnership audits, while (so far) having no rights to participate. And the PR need not be an individual, or even a partner.13
Certain partnerships will be permitted to opt out of the new audit procedures.14 Those that opt out will fall back into the pre-TEFRA audit procedures, under which the IRS must audit, assess and collect tax deficiencies from each ultimate partner, separately. We think that change is near the top of the Treasury’s wish list for a technical corrections bill. The first step in determining whether the opt-out election is available is based on a head count. A partnership can opt out only if it has 100 or fewer partners, all of which must be individuals, S corporations, C corporations or estates of deceased partners. And if the partnership has an S corporation partner, it must count each of its shareholders against the 100-partner limit.17 Unless the IRS issues guidance to the contrary, if even one partner is another partnership, or a disregarded single-member LLC or a grantor trust or any other type of trust, the...