United States: Recent Revisions To Partnership Audit Rules Will Affect Existing And Future Tax Partnerships

Last Updated: January 4 2016
Article by Alvin J. Goldman, Donald A. Hammett and Thomas M. Stephens

Congress recently passed the Bipartisan Budget Act of 2015. Among its revenue-raising provisions is a repeal of the current tax matters partner (TMP) rules with regard to tax audits of, and tax adjustments concerning, partnerships (including limited liability companies that are partnerships for federal income tax purposes), and the enactment of a new regime intended to streamline tax enforcement against partnerships, especially large partnerships. Although these new rules only take effect for returns filed with respect to partnership years starting after 2017, new partnership or limited liability company (LLC) operating agreements drafted now or in the future should take these new rules into account. Also, partnership or operating agreements currently in existence should be reviewed, and most likely amended, with these new rules in mind.

Under the current rules, the TMP is the primary point of contact with the IRS during an audit, but has limited authority to bind partners, and each partner has the right to participate in an audit or contest involving the partnership. In place of the current TMP role, the new rules provide for a "partnership representative," a person to be named by a partnership. The partnership representative can (but need not) be a partner, but must have a substantial presence within the US. Unlike the current TMP provisions, the partnership representative has the absolute right to bind the partnership in any settlement or audit. The new rules do not even provide, as the current audit rules do, for giving notice to partners as to proposed audits, adjustments or other matters. Therefore, it is critical that the partnership or operating agreement define the partners' respective rights among themselves with regard to partnership audits and related adjustments.

Even more significant are the changes involving liability for adjustments. Under the current rules, an audit of a partnership (other than a "large" partnership) which results in an adjustment to its tax return leads to changes having to be made in the tax returns for the year under audit of each of the partners, who are solely responsible for any resulting tax increase. Under the new rules, the partnership itself generally will be liable to pay, as a current year tax liability, any tax increase resulting from an audit. As a result, the former "pass-through" nature of a partnership has been changed insofar as a tax liability resulting from an audit is concerned.

As a general matter, the tax imposed on the partnership as a result of an audit change will be calculated at the highest rate of tax in effect for the reviewed year, taking into account the nature of the income involved. However, there are provisions that require the Secretary of the Treasury to adopt procedures to modify the tax imposed on the partnership to reflect income allocable to tax-exempt partners, and certain other partners subject to lower rates of tax. Subject to limited exceptions, the tax will be borne by the partnership as composed for the year during which the adjustment is made (rather than, as now, the partners for the year under audit). Thus, the partnership could have liability for adjustments even if some or all of the partners have changed since the year under audit. Moreover, if a partnership ceased to exist before an adjustment is made, the former partners of the partnership will remain responsible for the tax liability. Therefore, it will remain an issue for current and former partners to determine how any tax liability will be borne among them.

Once a tax liability has been imposed, a partnership is afforded an election to avoid liability by shifting the adjustment (proposed for the tax year under audit) to the tax returns of the partners for that year by notifying the IRS and the partners of each partner's allocable share of the adjustment, in which case the partners will themselves pay their share of the tax liability, as would be the case under current law. This election mitigates some of the harshness that could otherwise result from these new provisions, but partners are well advised to appropriately document the authority to make this election, as it will result in the partners (for the reviewed year in question) paying their share of the tax liability. The time periods for making such an election are not lengthy, so larger partnerships will need to have procedures in place to enable an election to be made if desired. The importance of carefully drafted provisions in the partnership or operating agreement is heightened when one considers the various conflicts of interest that can result under these rules, including for example a taxpayer representative who is a partner deciding whether to elect that the then-current partnership or the partners for the reviewed year in question should pay any tax liability assessed by the IRS in a situation where such partner's percentage interest has been reduced in the interim.

A partnership that has 100 or fewer partners can opt out of these new rules on an annual basis, and thereby continue with the current partnership audit rules. However, this option is only available if each of the partners is an individual, a C corporation (including a foreign entity which would be treated as a C corporation if it were a domestic entity), an S corporation or an estate of a deceased partner. For purposes of this option and the determination of whether a partnership has 100 or fewer partners, each shareholder of an S corporation that is a partner is generally treated as a separate partner. Note that, in the absence of yet-to-be-drafted regulations, a partnership that has as a partner a trust (except perhaps a grantor trust) or another partnership would not be eligible to opt out. However, the act permits the IRS to apply "look through" rules similar to those stated for S corporations to other entities.

The new rules make important changes to the statute of limitations for assessments of partnership tax items. Currently, the statute of limitations period for assessments concerning partnership tax items is generally the statute of limitations period of the partnership, but such period can be extended for a particular partner so long as the separate assessment period for that partner remains open. The new rules contain a single partnership statute of limitations. An adjustment cannot be made to partnership tax items (absent fraud or serious omission of gross income) more than three years after the latest of (i) the date the partnership filed its tax return, (ii) the due date for the partnership's tax return or (iii) the date on which the partnership filed with the IRS a request for an administrative adjustment to its previously filed tax return. Thus, a partner that extends the assessment period for its own tax return is not simultaneously keeping open the assessment period for the partnership's tax return.

These new rules require substantial fleshing out by the IRS, presumably in the form of notices and proposed regulations to be issued within the next several years. In some areas, Congress may have to fill in the blanks. In the meanwhile, as stated above, new partnership and operating agreements will require provisions dealing with these rules, and existing agreements will likely require amendments to take them into account. Dentons' Tax practice has prepared form provisions to address these matters.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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