On November 2, 2015, the Bipartisan Budget Act of 2015, (the Act), H.R. 1314, 114 Congress/Public Law No. 114-74, made significant changes to the rules governing US federal income tax audits of partnerships (New Audit Rules). The New Audit Rules are codified at Internal Revenue Code Sections 6221 through 6241. On August 4, 2016, the IRS released temporary and proposed regulations relating to certain aspects of the New Audit Rules. And, on December 6, 2016, technical corrections to the New Audit Rules (Technical Corrections) were introduced in both the House of Representatives, H.R. 6439, and in the Senate, S. 3506.
On November 2, 2015, the Bipartisan Budget Act of 2015 was signed into law, and which instituted significant changes to the rules governing the federal tax audits of partnerships for tax years after 2017. In the absence of affirmatively electing partner-level adjustment, the new rules impose entity-level tax liability for Internal Revenue Service (IRS) audit adjustments to partnerships. The new rules are a significant departure from what has historically been merely pass-through treatment of partnerships for US federal income tax issues.
There is a small partnership exception to elect out of the new audit rules. This election may apply to partnerships with 100 or fewer partners, each of which is an individual, a C corporation, an S corporation or an estate of a deceased partner. However, any tiered partnership – partnerships that have partnerships as partners – are ineligible for the exception.
The new rules determine IRS audit adjustments at the partnership level for items of partnership income, gain, loss, deduction or credit. The taxes owed on those adjustments are calculated at the maximum statutory tax rate, and assessed and collected from the partnership in the year that the audit or any judicial review is completed. Additionally, the partnership is liable for all associated penalties and interest.
Alternatively, the partnership can elect out of the entity-level tax, but must furnish to every partner for each year under examination a statement of the partner’s share of any tax adjustments. Under this election, each partner will be responsible for paying its taxes, penalties and interest related to the adjustment.
The new rules also change who speaks to the IRS on behalf of the partnership. Instead of the “tax matters partner,” the new rules provide for a “partnership representative.” The partnership representative, who no longer must be a partner, has sole power to act on behalf of the partnership during the audit. Moreover, the partnership representative can bind both the partnership and the partners with respect to the IRS examination and adjustments.
The new partnership audit regime applies to partnership returns filed for tax years beginning after December 31, 2017. Because the new rules make fundamental changes to the way that partnerships were audited in the past, we are hopeful that the delayed effective date will give taxpayers time to consider the potential effects of the new rules on their partnerships and operative agreements. The new rules leave open numerous issues, and we expect the IRS to issue substantial guidance in the future.