The IRS is Coming: How to Prepare for the New IRS Partnership Audit Rules
The Bipartisan Budget Act of 2015 puts into place several significant changes that partnerships should consider now before the law goes into effect on January 1, 2018.
If you ask an accountant whether he or she has advised on an IRS partnership audit, the likely answer is “no”. In the past, the IRS rarely audited partnerships, and when America’s least favorite agency showed up at a partnership’s door, that partners often went through the audit unscathed because the partnership audit rules were so burdensome for the IRS. Those days are over. In an effort to increase IRS audits of entities taxed as partnerships, Congress recently passed the most sweeping change to the partnership audit rules in more than 30 years. These new rules, buried in the Bipartisan Budget Act of 2015 (BBA), do more than impact partnership audits. The rules effectively impose an entity-level tax on partnerships, taking away one of the greatest benefits of organizing as a partnership. Moreover, the BBA puts into place a number of other significant changes that partnerships should consider now before the law goes into effect on January 1, 2018.
These new rules will have a tremendous impact on small partnerships, limited liability companies (“LLCs”) and other entities taxed as partnerships. Gone is the small partnership exception from Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”); small partnerships and LLCs must now elect out annually to avoid the cumbersome BBA rules. Given the breadth of the BBA changes discussed below, all partnerships and LLCs must amend their agreements to ensure that that the appropriate BBA provisions are included.
In Part I of this series, we review the law on partnership audits over the last 30 years and then contrast the IRS audit rules under the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”), which are in effect until 2018, and those in the newly-enacted BBA. In later parts, we will examine the Treasury Regulations and IRS guidance on the BBA as well as how your partnership or clients should respond to these changes.
Background
Partnerships and LLCs have become a popular entity choice for doing business over the past 50 years. Since 2003, the number of partnerships has grown at an average annual rate of 3.9 percent, with over 3,300,000 entities filing partnership tax returns in 2012 (see Figure A). LLCs and small partnerships have accounted for the majority of this growth.
Figure A
IRS tax enforcement efforts have been unable to keep up with the increase in number of partnerships and LLCs. According to IRS data, the IRS audited only 0.47 percent of partnership returns in 2012, with barely half actually receiving any type of adjustment. The lack of adjustments has less to do with a partnership accurately reporting its tax position, and more to do with the cumbersome and ineffective TEFRA partnership audit rules. To fully appreciate why Congress replaced TEFRA with the BBA, it helps to see why Congress enacted TEFRA in the first place.
Prior to 1982, the IRS did not audit partnerships; rather, the IRS examined the income tax return of each individual partner of a partnership in making tax adjustments. As syndicated partnership tax shelters and multi-tiered partnerships became more prevalent, the process of conducting audits became more inefficient and costly for the IRS. Partnerships often included thousands of partners, making it impossible for the IRS to audit all the partners within the statute of limitations or locate all the partners to obtain a statute extension. The IRS also had less incentive to settle because the settlement would only bind those partners who were parties to the settlement.
In response to pleas from the IRS to create a more workable audit process, Congress passed TEFRA in 1982 to create a unified audit procedure for all but certain small partnerships. TEFRA equipped the IRS with the tools to attack syndicated partnership tax shelters; however, TEFRA was not designed to deal with the proliferations of legitimate partnerships that we have seen over the past 30 years.
TEFRA shifted audits away from individual partners to the partnership. Under the law, the tax treatment of all “partnership items” (e.g., income, deductions, credits) as well as penalties, additions to tax, or additional amounts that relate to a partnership item must be made at the partnership level. TEFRA encouraged partnerships to name a partner as tax matters partner (“TMP”) to serve as the primary representative in dealing with the IRS during the audit. The TMP coordinates the audit and keeps the partners informed, but each partner generally has the right to participate in his or her own separate proceeding and to negotiate his or her own settlement with the IRS. At the conclusion of the audit, the IRS mails the TMP and other partners a notice of final partnership administrative adjustment (“FPAA”). Thereafter, the TMP (or another partner) may file suit in the U.S. Tax Court, a U.S. district court, or U.S. Court of Federal Claims. Following all IRS and court challenges, the partnership item adjustments flow through to the partners to pay assessed tax, penalties, and interest.
The IRS found the TEFRA rules improved audits of some partnerships, but were virtually useless in auditing large partnerships (those with 100 or more direct and indirect partners). Large partnership audits became very time intensive for the IRS due to the sheer number of partners and the ability that each partner had to intervene in the audit. Consequently, Congress modified TEFRA to include new IRS audit rules for large partnerships known as the “Electing Large Partnership (ELP) Regime” in 1997. The ELP Regime differed from TEFRA in a number of ways. The primary goal of the ELP Regime was to lessen the administrative work for the IRS by requiring the partnership (rather than the individual partners) to pay the tax and requiring fewer notices to partners. Moreover, any IRS adjustments flowed through in the year of adjustment, not the tax year in question. Interestingly, the 1997 law did not require large partnerships to enter the ELP Regime but allowed them to elect in. Not surprisingly, few partnerships elected in because doing so would only make it easier for the IRS to audit them.
In a 2014 report, the Government Accountability Office found that from 2002 to 2011, the number of large partnerships more than tripled to 10,099 and almost two-thirds of large partnerships had more than 1,000 direct and indirect partners. It would often take months for the IRS auditor to identify the TMP, giving the IRS little time to actually audit and make the necessary adjustments before the statute of limitations on assessment expired. The process by which the IRS determines each partner’s share of the adjustment became time consuming and labor intensive. In fact, a Treasury report found that since 2010, the IRS has failed to assess taxable partners approximately $14.5 million resulting from audits of partnership returns. As a result, almost all large partnerships avoided the audit process solely because of their entity structure. Political leaders on both sides of the aisle called for significant changes to TEFRA, if not repeal and replacement. It took Congress looking for revenue for the TEFRA regime to be put to rest.
Bipartisan Budget Act of 2015
In 2015, Congress was working on passing its budget, and it needed to find revenue to offset spending in the bill. Congressman Jim Renacci introduced a bill earlier in the year, the Partnership Audit Simplification Act, which essentially forced all partnerships into the ELP Regime. The shift of collecting tax at the partnership, rather than partner, level would have made IRS audits of partnerships and LLCs much easier (and much more likely) and the Joint Committee on Taxation estimated $9.35 billion over ten years in revenue from such audits. Though many members and practitioners took issue with provisions in the Renacci bill, the general framework was added to the BBA, and after significant changes, a new IRS partnership audit regime was born.
Entity-Level Tax
The most controversial provision within the BBA is the entity-level tax. As discussed above, TEFRA required the IRS to pass adjustments down to the partners following the partnership audit. By contrast, under the BBA, the IRS collects taxes associated with audit adjustments at the partnership level, effectively imposing an entity-level tax on the partnership itself. The IRS nets all adjustments and imposes an “imputed underpayment” taxed at the highest individual or corporate tax rate at the conclusion of a BBA audit. Issues clearly arise where the partnership includes tax-exempt entities or partners with significant net operating losses that would not be subject to tax. Congress punted on these issues and asked that the IRS and Treasury Department issue additional guidance on how to treat the imputed underpayment in such cases. A partnership seeking to reduce its imputed underpayment must supply supporting documentation to the IRS within 270 days of issuance of the proposed partnership adjustment.
Furthermore, the BBA requires the IRS to assess the partnership for the current year (known as the “adjustment year”) rather than the audited year (known as the “reviewed year”). This puts the economic burden of the tax on the current year partners, who may not have had any interest in the partnership during the reviewed tax year. Here’s an example to illustrate how this works under the BBA. In 2018, an oil and gas drilling partnership passed down unwarranted deductions that each partner took on his or her tax return. In 2019, Partner A sells his interest to Partner B, a new partner to the partnership. In 2020, the IRS audits the partnership for tax year 2018; 2020 is considered the adjustment year and 2018 is considered the reviewed year. The IRS determines that the deductions were unwarranted and requires the partnership to pay additional tax for the 2018 tax year. Partner B would be liable, by way of his present interest in the partnership, for any taxes, penalties, and interest the IRS assesses for 2018, even though Partner B lacked any economic interest in the partnership during that year.
Opting-Out
All partnerships are subject to the BBA unless the partnership elects out. This includes small family limited partnerships with royalty interests to MLPs with thousands of miles of pipeline. The BBA offers an exception to the entity-level tax in the adjustment year, though the usefulness of such exception remains to be seen. The partnership can “push out” the adjustments to its reviewed year partners by providing them with adjusted Schedules K-1 reporting their allocable share of any partnership-level audit adjustments. This must be done within 45 days from the date of the final partnership adjustment, and results in an additional two percent interest rate hike on any underpayment. It’s highly unlikely that a large MLP, a fixture in the midstream oil and gas industry with partnership shares trading daily, could even locate the partners within 45 days, much less prepare and send out adjusted Schedules K-1. If a partnership can meet the deadline, the imputed payment obligation passes to the reviewed year partner.
In addition, qualified partnerships may elect out of the BBA regime, so long as the partnership properly elects out on the Form 1065 every year. A partnership qualifies for this exception if it (i) furnishes 100 or fewer Schedules K-1 with respect to its partners, and (ii) each of its partners is an individual, a C corporation, any foreign entity that would be treated as a C corporation were it domestic, an S corporation, or an estate of a deceased partner. In other words, a partnership with a trust or partnership as a partner may be ineligible to elect out. The forthcoming Treasury regulations should address whether having a trust or partnership as a partner will make a partnership ineligible to elect out of the BBA. If the partnership is eligible, it must notify each partner of this election. In such case, the IRS examines each partner separately, which could result in inconsistent treatment among partners. This differs from the TEFRA small partnership exception for partnerships with 10 or fewer partners.
Partnership Representative
The BBA also creates a new role within a partnership called the “partnership representative.” The role bears some similarity to the TMP under TEFRA, but with significantly more authority. The TMP represents the partnership before the IRS and in federal civil litigation, and must keep the partners informed of the partnership proceedings. The TMP may be a general partner of a partnership or a member-manager of a limited liability company. If there is no TMP named in the partnership agreement, the IRS may select another partner as TMP based on specific ordering rules.
By contrast, the partnership representative has sole authority to act on behalf of the partnership and the partners, including in any IRS or court proceedings. The partnership representative need not be a partner; he or she need only have a substantial presence in the U.S. It is imperative that partnerships designate someone as the partnership representative; failure to do so gives the IRS the opportunity to appoint anyone, including theoretically the IRS agent themselves, to that role. We expect that the IRS and Treasury Department will issue considerable guidance on who can serve in this position over the coming months, and we will address such guidance in future editions of this newsletter.
Notification Provisions
Another consequential change relates to the notice provisions. Under TEFRA, the IRS must give most partners notice of all significant events in a TEFRA partnership proceeding, including notice at the commencement of the audit and when the IRS issues the FPAA. In addition, the TMP must furnish information to all “notice partners” and all representatives of “five-percent notice groups” of all significant audit and litigation events. Under the BBA, the IRS need only notify the partnership representative. Thus, if partners want to have notice of significant audit events that may result in large tax liabilities, notice provisions must be drafted into the partnership agreement or otherwise be contractually created.
Inconsistent Reporting
In some cases, a partner may choose to report a position inconsistent with how the partnership treats the position. Under TEFRA, a partner’s tax return must be consistent with the Schedule K-1 the partnership issued, unless the partner files a notice of inconsistent treatment. If a partner fails to file the notice, the IRS may treat any underpayment of tax resulting from the inconsistent position as a mere mathematical error or clerical error and can assess the tax without issuing a notice of deficiency. The BBA requires each partner to report items on its return consistently with the treatment on the partnership return. Similar to TEFRA, the BBA allows a partner to file a notice of inconsistent treatment or face assessment as a mathematical or clerical error. In Notice 2016-23, 2016-13 I.R.B. 490, the IRS requested comments regarding the rules for notifying the IRS of an inconsistent position under the BBA, the treatment of partners who properly file such notification, and whether the existing TEFRA framework for inconsistent partner returns should apply under the BBA regulations.
Administrative Adjustment Requests
As with TEFRA, partnerships may file an administrative adjustment request (“AAR”) to adjust its taxable income prior to the IRS issuing an FPAA. Under the BBA, the IRS treats any decrease in income or increase in loss as occurring in the year the AAR is filed, not the tax year in question. The BBA permits only the partnership representative to file the AAR. This is in contrast to TEFRA, which allowed either the TMP or an individual partner to file an AAR.
Conclusion
The BBA partnership audit rules should be of significant concern to all partnerships, not only because the partnership is more likely to be audited but also the partners must address and agree to a number of changes to the partnership agreement before the new audit rules go into effect on January 1, 2018. In the next part of this series we intend to discuss the proposed Treasury Regulations, what they mean for partnerships and LLCs, and what your clients should do to comply with the new law.
Endnotes
[1] A partnership is the relationship between two or more persons who join to carry on a trade or business. Each person contributes money, property, labor, or skill with the expectation of sharing in the profits and losses of the business, regardless of whether a formal partnership agreement was made. Every partnership that engages in trade or business, or has income from sources in the United States, must file an annual information return, Form 1065, U.S. Partnership Return of Income, or Form 1065-B, U.S. Return of Income for Electing Large Partnerships, with the Internal Revenue Service.
[2] An LLC may be classified for federal income tax purposes as a partnership, corporation, or an entity disregarded as separate from its owner by applying the rules in Regulations section 301.7701-3. In this article, when we discuss the effect the rules have on the BBA rules will have on LLCs, we are referring to those LLCs that have elected to be taxed as a partnership.
[3]Partnerships with less than three partners made up more than half (55.9 percent) of all partnerships. These same-sized partnerships accounted for more than a quarter (26 percent) of all partnerships with total assets of $100 million or more.
[4] See Treasury Inspector General for Tax Administration, 2015-30-004, Additional Improvements Are Needed to Measure the Success and Productivity of the Partnership Audit Process (Mar. 18, 2015).
Read The IRS is Coming: How to Prepare for the New IRS Partnership Audit Regime Part 2
About the Authors
Travis Austin Greaves is a tax attorney in Washington, D.C. Mr. Greaves concentrates his practice on federal and state civil and criminal tax controversies. He represents individuals, partnerships, and corporations through all stages of tax investigations and litigation, including voluntary disclosures, audits and examinations, audit reconsiderations, and negotiated resolutions with the IRS. In addition, Mr. Greaves is an Adjunct Professor at Georgetown University Law Center, where he has taught tax controversy courses. Mr. Greaves served as the Tax and Economic Policy Advisor to Louisiana Governor Bobby Jindal; practiced in the tax group of a major international law rm; and served as an Attorney Advisor at the United States Tax Court. You can contact Mr. Greaves via email at travis.greaves@gmail.com or by phone at 202-412-0019.
Joshua Wu is a tax attorney in Washington, D.C. A primary focus of Mr. Wu’s practice is helping startup companies, mid- size businesses, and individual clients remain in compliance with U.S. tax laws, as well as guiding clients on appropriate procedures to reduce their tax burdens. Mr. Wu represents clients in an array of tax controversies and tax litigation matters before the Internal Revenue Service (IRS), the U.S. Tax Court, the U.S. Court of Federal Claims, and the U.S. Court of Appeals for the Federal Circuit. With considerable experience handling multijurisdictional investigations, Mr. Wu regularly works with foreign companies, trusts, and advisors to resolve inbound U.S. tax and reporting issues. Heavily involved in the D.C. metro area startup community, Mr. Wu works with angel investors and coworking spaces to assist emerging companies implement business practices and legal structures to facilitate their growth and access to funding. You can contact Mr. Wu via email at josh.wu@gmail.com or by phone at 571-294-3850.
