On November 2, 2015, Congress passed the Bipartisan Budget Act of 2015, Section 1101 of which repeals the long-standing current rules for IRS audits of partnership entities and replaces those rules with a new centralized partnership audit regime that, in general, assesses and collects tax at the partnership level. This approach is contrary to the fact that partnerships are not subject to income tax - partners report and pay income tax on their share of partnership income. These new rules will become effective for returns filed for partnership taxable years beginning after December 31, 2017, although partnerships can elect to have these new rules apply to returns filed for partnership taxable years beginning after November 2, 2015 and before January 1, 2018.
Partnerships will have to make a number of decisions under these rules, and the failure to timely do so will, in some cases, put decision-making authority into the IRS's hands. This new audit regime will be a sea change and will require the amendment of existing partnership (and LLC) agreements to remove references to concepts under the old audit rules and replace them with provisions that address the new framework. Every partnership will be faced with important choices with respect to the application of the new rules. For instance, certain “small partnerships” (100 or fewer partners) are allowed to opt out of the new audit regime. However, there may be circumstances in which a partnership determines that the option out is not the best choice because each partner could be audited individually, with possibly varying results.
As another example, partnerships that are subject to the new audit regime will be subjected to the resulting tax (called the "imputed underpayment") at the partnership level, which means that the partners in the adjustment year will bear the financial burden of the underpayment; however, the partnership will have the option to modify (reduce) the imputed underpayment based on information related to the partners and/or to shift back liability for that underpayment to the persons who were partners during the reviewed year. These decisions are complicated by many factors and require judgment based on a careful analysis of the partnership’s business and owners.
Each of the elections afforded to partnerships should be addressed in the partnership agreement. In addition, there are many other issues that arise under the new rules that should be discussed and covered in the agreement. What happens if a partner sells some or all of his interest in the partnership between the year under audit and the year in which the audit gets resolved? Who bears responsibility for the underpayment and should this issue be covered in the agreement to purchase/sell the partnership interest? If the partnership pays the underpayment, how is it allocated to the partners? Does the partnership want to require partners to file amended returns for reviewed years, and how will the partnership gather and track this tax information? The list of questions to be addressed is long, and the answers will not all come easily.
Another key change made by the new legislation is replacement of the "tax matters partner" with a "partnership representative," who is authorized to act on behalf of the partnership with respect to the audit issues and to settle or litigate. The partnership representative does not have to be a partner in the partnership, but does need to be someone who is primarily located within the United States. The partnership representative will have significant fiduciary responsibilities to the partnership and its partners, and the selection of this person should be made with great care. The partnership agreement should address the rights and responsibilities of the partnership representative and the manner in which the representative will be chosen or replaced. If the position of partnership representative is vacant, the statute authorizes IRS to select that person; a partnership should never be in the position of having IRS determine who will be the partnership representative.
Congress vested a significant amount of authority in the IRS to promulgate regulations to implement the new audit regime, and the IRS is currently in the process of drafting those regulations. With respect to the formation of new partnerships and limited liability companies (to be taxed as partnerships), there is a question as to how much of the new audit regime material should be incorporated into the agreement at the time of formation. Future regulations may change the way in which the statute is applied, and those changes could necessitate amendment of the partnership agreement. Although practitioners are beginning to draft language addressing the new audit rules, until the IRS issues draft regulations for comment, the extent to which these regulations will impact analysis and drafting is unclear.
Over the next several months, we plan to issue additional advisories explaining the new audit regime in more detail, particularly as the IRS publishes proposed regulations for comments. Although 2018 feels a long way off, time goes by quickly, and during that time every entity taxed as a partnership should be working with their advisors to understand the new audit rules, discuss and determine the approach that makes the most sense for the entity and its owners and begin to prepare amendments to the partnership agreement to address the changes.
Until new regulations are promulgated by IRS, we will next address the rules as they relate to small partnerships and the complexities presented by the statutory language.