Partnership audit procedure rules will change in the new year

As part of the budget agreement enacted in November 2015, Congress replaced the rules that govern audit procedures for partnerships as established by the Tax Equity and Fiscal Responsibility Act of 1982. For audits of partnerships with partnership years beginning on or after January 2018, the TEFRA audit rules will no longer apply. These new partnership audit rules apply to partnership adjustments, which are all adjustments in gain, loss, credit or deduction amounts of the partnership or any related partner's distributive share. Under the new rules, adjustments are made at the partnership level, and the tax due as a result of adjustments is due at the partnership level.

Effectively, this partnership-level change means that current partners can be liable for taxes due on past years income if that prior year is adjusted. The reviewed year is the year being examined and the adjustment year is the one in which a tax due adjustment is made (later). Adjustments could end up impacting years beyond these two. These rules are effective for partnerships for tax years beginning with 2018, but partnerships may elect to adopt these rules for any year beginning after the statute's enactment. Certain small partnerships may elect out. Additionally, regulations meant to clarify the rules have been proposed but their adoption remains in flux. The regulations were initially proposed under the Obama administration and the Trump administration is still evaluating them. Left open is how the Internal Revenue Service will administer the new rules without regulations providing guidance.

Agreements affected include, but are not limited to, the partnership agreement or LLC operating agreement itself, purchase and sale agreements, contribution agreements, loan agreements, disclosure documents, contribution agreements, redemption and dissolution agreements, side letters and merger agreements. Key provisions are described below.

Election to opt out for "small" partnerships: Partnerships with 100 or fewer qualifying partners can elect out of the new rules. The election is made annually. Qualifying partners must be individuals, C Corporations (including foreign entities that would be treated as a C Corporation if they were a domestic entity), S Corporations, or estates of deceased partners. Trusts are not qualifying partners for this purpose (including under the proposed regulations). Given that many non-qualifying revocable trusts are currently partners in numerous partnerships, a great number of partnerships will not be able to elect out and will be forced to operate under the new rules. The partnership must notify each partner if an election to opt out is chosen and, if made, the IRS will make determinations at the partner level (as with TEFRA).

Partnership representative: A partnership representative must now be specifically designated and has the sole authority to act on behalf of the partnership. Unlike under TEFRA, partners do not have the right to participate in the proceedings or receive notice from the IRS. This representative does not have to be a partner and must be a "person" with a substantial United States presence. Under Internal Revenue Code Section 7701(a)(1), "person" includes an individual, trust, estate, partnership, association, company or corporation. Substantial United States presence is not defined, but Treasury Regulation Section 301.7701(b)-1 does provide some guidance. The IRS will appoint a personal representative if the partnership does not designate one.

Partnership-level determination: All partners are bound by a final resolution in the partnership proceedings. Penalties are also determined at the partnership level thus no partner-level defenses regarding penalties exist Also, the only relevant statute of limitations are those of the partnership and the attributes of limitations are based solely upon when the partnership return was filed. A partner's statute of limitations is only taken into account if the partnership elects out of the new rules.

Push out election: A push out election is provided, which allows the partnership to elect that the review year partners individually take into account the adjustments made by the IRS instead of having the partnership pay the imputed underpayment itself in the adjustment year. If a push out election is made, the review, adjustments and payments due happen at the partner, not partnership, level. Any partner can elect to issue adjusted statements (basically, an amended K-1) to all partners who were such during the year under review, and the IRS also gets copies. This election must be done within 45 days of the final partnership adjustment receipt (a very short period!). Partners must pay any related tax due in the year the statement is issued, but the tax due is the amount that would have been owed in the review year and following years (the latter due to any adjustments that carry forward), and based on the adjustment. Reviewed year partners can also be liable for penalties and interest. The reviewed year partners have no right to an administrative or judicial review, they are not required to consent to amended statements and they are bound by the partnership level determination. There is no joint and several liability for partners, but left unclear is if the partnership must pay any tax that a reviewed year partner refuses to pay.

Partnership tax assessment, or "imputed underpayment amount": Adjustments to income, gain, deduction and loss are netted, and then tax is applied at the highest (personal of 39.6 percent or corporate of 35 percent) rates in the Internal Revenue Code. Conceptually, adjustments are considered based on buckets applicable to different categories. The partnership can submit evidence to reduce an imputed underpayment by the portion allotted to a partner which is a tax exempt entity and related adjustment which would be exempt from tax. The partnership can also submit evidence to modify the applicable highest tax rate, the specifics of which exceed the depth of this overview analysis. Any increase or decrease in loss is treated as a decrease or increase in income. Following computation of the imputed underpayment amount, changes to credits are taken into consideration as increases or decreases in the imputed underpayment amount. Tax assessment is for the adjustment year, not the reviewed year.

When are amended statements issued: Terms in an agreement should make the circumstances and timing very clear with respect to the requirement and timing for amended statements. Adjustments and allocations should also be clearly defined. Steps related to not being able to find a former partner are also important.

Impact on partnership governance and other partnership agreements: Drafting issues relate to the partnership representative, provisions allowing or requiring an election out or push out elections, escrow and indemnification provisions when a partner sells their interest, provisions requiring flow though related entities to share information, provisions regarding adjusted partner statements, information sharing and allocation of tax payments among partners.

Impact on other agreements: Lenders might require a covenant to make an election out or a push out elections. With purchase agreements, clarity on tax liability dating back and covenants/indemnifications with respect to these past amounts is to be expected. Also key to address for purchasers are covenants to (prospectively) make an election out or a push out election (the tax due will date to prior years, but will be due from the new partners, such as the buyer having to pay for taxes the seller "owed"). Redemption and dissolution agreements will share the same issues. Disclosure language in an agreement should clarify that the IRS can make adjustments to prior years and require current partners to pay that shortfall.

The new partnership rules will get further clarified over time, either through the proposed regulations, repeal or revision from the Trump administration or judicial precedence. They are currently clear enough that careful language in partnership agreements can direct certain outcomes as desired by the (majority of) partners with careful and often customized contract drafting. Multi-tiered partnerships have additional challenges as the rules are less clear with respect to many of their complexities.