As of Jan. 1, the Internal Revenue Service regulations implementing the new partnership audit rules — also known as the New Rules — which were enacted in 2015 by the Bipartisan Budget Act of 2015, became effective.
The new federal partnership tax audit regime (as now in effect) dramatically changes the landscape for pass-through entities by making partnerships, and not the partners, liable for payments of any federal taxes assessed as a result of an audit at the partnership level.
Before the implementation of the New Rules, the IRS would collect any underpayment of U.S. federal income tax (including penalties and interest), owing as a result of an audit of the partnership, directly from the partners and not the partnership. It is evident by this change, that a main objective of the New Rules is to relieve the IRS’s burden of having to pursue individual partners to collect taxes (and any associated penalties and interest) assessed as a result of the IRS’s income tax audits of the partnerships.
Additionally, the New Rules attempt to simplify and streamline the procedures for auditing all partnerships by requiring partnerships to designate a representative to act on their behalf.
This radical revamp of partnership audit rules impacts every partnership and limited liability company taxed as a partnership. It is strongly recommended that every entity treated as a partnership for U.S. federal income tax purposes revise its operating documents(s) (e.g., partnership agreement or operating agreement) to address the issues that arise with respect to the New Rules.
Before the New Rules, partnerships generally were required to appoint a “tax matters partner” to represent the partnership in connection with U.S. federal income tax audits. The New Rules eliminate this concept and now require that each partnership designate a “partnership representative,” who will have the sole authority to act on behalf of the partnership in connection with an audit or judicial procedures without the consent of the partners.
It is worth mentioning that unlike a “tax matters partner” under the old rules, the “partnership representative” need not be a partner so long as such person has substantial presence in the U.S. This change is beneficial especially for certain investment vehicles that could appoint a non-partner management company or investment advisor to act as the “partnership representative.”
Given these changes, it is recommended that individual partners seek to amend governing documents and strengthen contractual protections addressing issues that may arise in connection with federal income tax audits or judicial procedures. Such protections may include covenants requiring the “partnership representative” to provide information and/or notices relating to federal income tax audits or judicial procedures, or obtain consent from the partners before acting in any way that could bind the partnership.
Responsibility for Imputed Underpayment
The IRS is no longer required to individually assess each partner’s share of any tax due as a result of a partnership audit. So pursuant to the New Rules, the partnership itself is responsible for imputed underpayment.
Fundamentally, this means that the current partners at the time of the audit are responsible for the payment of the tax imputed for the tax year being audited, even if there were different partners for the tax year that was reviewed by the IRS. This could present a mismatch of the tax burden among the partners for that period.
Partnership may wish to address liabilities arising from this change by contractually providing for indemnity and reimbursement obligations from current and former partners.
There is a limited exception for certain eligible partnerships to opt-out of the New Rules. Such an election may be made only if the following requirements are met: the partnership has 100 or fewer partners, and each partner is an individual, a decedent’s estate, a C corporation, an S corporation or a foreign entity that would be treated as a C corporation if it were a domestic entity. The opt-out election is not available to partnerships that have a flow-through entity as a partner.
Further, a partnership must opt out of the New Rules on its tax return (timely filed) and notify each of its partners within 30 days of making such election. If no election occurs, the New Rules apply to all partners in the partnership.
Partnerships may also elect to push out the obligations, meaning that a partnership may choose to shift the obligation to pay any imputed underpayment (and any penalties, interest and additional tax) to the partners of the partnership during the reviewed year. The partnership is required to make the push-out election within 45 days of the date of the notice of final partnership adjustment from the IRS.
Under the New Rules, if choosing the push-out election, the partnership must furnish amended Schedule K-1s to the review year partners. Under this election, penalties, interest, and additions to tax are paid by each partner of the review year.
The effect of the New Rules is significant and partnerships that have not taken any actions to amend or revise existing operating documents should do so accordingly to avoid impacts both with respect to economics and control of the partnership in connection with the New Rules.
Driscoll R. Ugarte is a corporate law attorney and a partner in Duane Morris’ Miami and Boca Raton offices. He counsels public, domestic and foreign corporations through all stages of development and advises public and private business organizations in a range of corporate matters. He can be reached at DRUgarte@duanemorris.com.