Last week, President Obama signed into law the Bipartisan Budget Act of 2015. While there has been news coverage about the budget agreement, little attention has been paid to the fact that it dramatically changed the manner in which partnerships (including LLCs that are taxed as partnerships) are audited.
Currently, most partnership audits are covered by TEFRA, the Tax Equity and Fiscal Responsibility Act of 1982. Under TEFRA, partnership audits and any corresponding judicial proceedings are conducted at the partnership level. Once concluded, any adjustments resulting from the partnership audit are then made at the partner level, and the affected partners are assessed for their share of any federal income taxes resulting from the partnership adjustments. The adjustments impact those partners that were partners for the tax year being audited. This is true even if there has been a subsequent change in the ownership of the partnership. For example, assume a partnership audit results in an additional $1 million of taxable income for the 2013 tax year. This adjustment would result in an adjustment to the tax returns of the partners who owned the partnership in 2013, even if these partners had sold their partnership interests in 2014.
The new rules, though, proclaim to streamline and simplify the process. The partnership proceeding will still be conducted at the partnership level. However, the new rules provide that any adjustments to the partnership tax return for the year under audit (the "reviewed year") are taken into account by the partnership in the year that the audit or judicial proceeding is completed (the "adjustment year"). Any tax liability resulting from the adjustment is imposed on the partnership in the adjustment year. This is a dramatic departure from the existing audit rules. Not only does it impose the tax liability on the partnership, it shifts the liability to the adjustment year. In effect, the new rules default to putting the tax liability on the adjustment year partners, even if these partners were not the reviewed year partners. The partnership may elect out of these default rules by issuing statements to the reviewed year partners identifying their shares of the partnership adjustments, in which case the reviewed year partners would be required to take the adjustments into account on their returns and pay any tax due. Because this election can shift who bears the burden for tax adjustments, partnership agreements and, more importantly, partnership interest purchase and sale agreements will want to address specifically whether a partnership can make such an election.
The new rules also replace the tax matters partner with a "partnership representative." The partnership representative has absolute authority to bind the partnership on tax matters, and unlike the tax matters partner, does not have to be a partner. The selection of this partnership representative will be a critical business point for partnerships, as the partners will no longer have the right to receive notice of tax proceedings or to bring a separate action to contest adjustments agreed to by the partnership representative.
These new audit rules will be effective for partnership tax years beginning after December 31, 2017. If the partnership has 100 or fewer partners, the partnership can affirmatively elect out of the new rules. The partnership will need to make this election for each tax year. However, a partnership cannot elect out if any of its partners includes a partnership. For this reason, many businesses with partnerships will find themselves subject to the new rules.
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