How to plan for new partnership audit rules
When the Bipartisan Budget Act of 2015 became law in November 2015, the effective date seemed far in the future. Now, the Jan. 1, 2018, effective date is fast approaching and, if we have learned anything in the past 14 months, it’s that these rules raise more issues than anyone (including the IRS) thought they would. That is why partners (which for purposes of this alert include members in a limited liability company) need to start discussing the implementation of the new rules now and amend their partnership/operating agreements appropriately before the effective date.
Key Changes to Prepare For
- In most cases the IRS will be able to assess any additional tax resulting from an audit against the partnership itself – eliminating the need to proceed against individual partners. The assessment will be made against the partnership the year the audit concludes, and payment will be made from the partnership assets that year. That means those who are partners the year the audit concludes will bear the economic impact of the assessment – not those who were partners the year under audit.
- Every partnership will have to appoint a partnership representative who will have exclusive authority to represent the partnership before the IRS and to make every decision relating to certain elections, audits, and settlements with the IRS.
New Audit ProceduresUnder the new audit rules, the IRS will examine the partnership’s tax return, and if an assessment results, the partnership itself will (with a number of exceptions described in this alert) be responsible for any adjustments the year the audit is completed, or the year that any judicial proceeding relating to the audit becomes final. This is a significant change because partnerships have never before been required to pay tax at the partnership level. It is also significant because a partner who benefitted from an aggressive deduction (for instance) taken the year under audit but who leaves the partnership before the audit takes place will not have to pay their share of the assessment. Instead, the remaining partners or even worse, a new partner will be responsible for the tax liability since it will be paid out of partnership assets when the audit concludes.
Calculating the Tax DueAn important element of the new rules is the tax rate imposed on the additional income that results from any audit adjustment. The tax resulting from the audit adjustment is referred to as the “imputed underpayment,” and is calculated by multiplying the net increase in income resulting from the audit by the highest income tax rate in the Internal Revenue Code, which is currently the individual tax rate (39.6 percent). This rate and the resulting tax liability can be modified if the partnership shows that a lower amount is appropriate based on the tax rates applicable to the actual partners. Modifications to the imputed underpayment can be made in instances where:
- A partner files an amended return for the tax year at issue reflecting its share of the partnership level adjustments, and the resulting tax is paid by the partner. In other words, a partner taxed at a rate lower than the highest individual rate could file an amended return reflecting its share of the audit adjustments and pay the tax on that adjustment at the lower rate. The partnership is then not responsible for tax on this part of the additional income resulting from the audit. This is provided for under Internal Revenue Code Section 6225 and is referred to herein as “Section 6225 Reporting.”
- The partnership shows that part of the underpayment is allocable to a tax-exempt partner.
- The partnership shows that part of the underpayment is allocable to a C corporation (in the case of ordinary income) because C corporations generally are taxed at a rate lower than individuals.
- The partnership demonstrates that part of the underpayment is allocable to an individual (in the case of capital gains income) because individuals generally are taxed at lower rates on capital gain income.
How to opt out of the New Rules.There are a number of ways a partnership can opt out of some or all of the provisions of the new audit rules. These exceptions are, however, very narrow and introduce additional complexity in their implementation.
The Section 6221 Opt OutThis provides for the true “opt out” election, meaning the partnership takes itself completely out of the new rules. It is unfortunately very limited. This election is only available to partnerships with 100 or fewer partners that meet certain criteria (generally individuals, corporations and estates of deceased partners). This requirement precludes any partnership with a partner that is a trust from making the election, eliminating the availability of this election for many partnerships, since it is common to have partners that are grantor trusts. Partnerships that can meet these ownership tests will be allowed to completely opt out of the new audit rules and have audits performed at the individual partner level. To take advantage of this exception, the partnership must make a “Section 6221 election” on its tax return for the year it wishes to opt out, and the names and taxpayer ID numbers of each partner must be provided to the IRS. Additionally, each partner must be given notice of the election. If an S corporation is a partner, the names and taxpayer ID numbers of each shareholder of that S corporation must also be provided. Although this provision allows certain partnership to escape the new audit rules, it is unlikely that these partnerships will be subject to a lower risk of audit, since the IRS will only have to collect an assessment form one “layer" of partners and will have all of the partners’ taxpayer ID numbers.It is important to note that even partnerships opting out of the audit rules with a Section 6221 election must appoint a partnership representative.
The Section 6226 Push-out.Although there is only one true “opt out” provision where a partnership can completely elect out of the new audit rules, there are several ways that partnerships will be able to opt out of those sections of the audit rules imposing the assessment liability on the partnership itself. A Section 6226 election will be available, where the partnership can choose to issue adjusted information returns to its partners showing their share of the audit adjustment, instead of having the partnership pay the tax liability. The partnership must make this election within 45 days of receiving notice of the final audit adjustment. If the election is made, the partners will, after receiving the information return, report the income and pay the additional taxes through a simplified amended return process using either the calculation rules set forth in the regulations or a “safe harbor” amount. The regulations allow a partner to calculate the additional tax as though the adjustment had been made in the year under audit (taking into account the partner's actual tax rate and other tax attributes), whereas the safe harbor payment is simply calculated using the highest individual tax rate. Importantly, the adjusted income information is issued to those who were partners in the year under audit, even if they are not partners in the year that the audit is performed and the assessment is made against the partnership. This ensures that new partners will not be responsible for taxes of partners who have left the partnership after the year under audit, but prior to the audit itself. This election is sometimes referred to as a “push-out” election since the tax liability resulting from the audit is pushed out to the partners. There is at least one cost to using this election – interest on any underpayment will be assessed at a rate that is 2 percent higher than if the partnership had paid the tax.
Section 6225 Reporting.The final way to keep the partnership from having to pay any of the assessment is to have all of the partners agree to make the amended return filing under Section 6225. If the entire amount of the assessment is reflected on the partners' amended returns, the partnership itself would obviously not be liable for the assessment. This may be especially attractive where partners in the partnership have a number of different tax rates, since each partner pays on its share of the assessment at its own rate. Unlike a Section 6226 election, this provision would require that all of the partners agree to file amended returns to keep the partnership from being assessed. Confirming compliance with this process, which would have to be a requirement in the partnership's partnership/operating agreement, may be difficult if there are more than a few partners.
The Role of the Partnership Representative (Formerly the Tax Matters Partner)The second major change included in the new audit rules is the implementation of rules requiring a partnership representative. Under the current rules, partners usually give little thought as to who will serve as the tax matters partner (TMP). The TMP is only relevant in certain types of partnership audit proceedings, and individual partners generally have the right to participate in these proceedings. Since the authority of the TMP is therefore limited, attorneys rarely have lengthy discussions about the ramifications of naming a TMP. Under the new audit rules, Code Section 6223 provides that the role of the TMP is replaced by a “partnership representative” who has complete authority to act on behalf of the partnership (and therefore effectively the partners) when dealing with the IRS. This authority includes the ability to bind the partnership and the partners with respect to audits and other proceedings, including settlement authority and decisions on procedural issues such as extending the statute of limitations and whether to proceed to litigation. The proposed Regulations make it clear that the partnership representative also has the authority to make the Section 6226 “push-out” election on behalf of the partnership. Significantly, there is no legal obligation under the IRS rules for the partnership representative to keep partners updated on the status of the audit or even to notify the partners of the audit. Finally, unlike a TMP, the partnership representative does not even need to be a partner of the partnership. If a partnership does not designate a partnership representative the IRS “may select any person as the partnership representative.” These changes in the role of the former TMP are significant and raise issues that every partnership agreement and operating agreement should address.
Issues to address NOWIn light of the drastic changes to the partnership audit rules as described above, there are a number of changes that partnerships and LLCs should consider making to their partnership or operating agreements – and it’s important to begin considering these issues now.
Will you make one of the available elections?One of the first issues to be considered by any partnership is whether the partnership should make one of the available elections under new audit rules, either by choosing to opt out of the new rules entirely (for eligible partnerships) or by choosing one of the alternative methods of reporting the assessment at the partner level. While the initial reaction might be that opting out is always desirable, the new audit rules may actually provide an administrative benefit for some partnerships. Although it is more difficult for the IRS to audit the returns of the individual partners rather than the partnership itself, an audit of the individual partners also means each partner will have to spend a significant amount of time complying with information requests and other audit-related matters. With the Section 6226 “push-out” election, assuming the partners have not changed during the years at issue, it may be easier for the partners, as well as the IRS, to simply have the IRS audit and assess the partnership instead of having the partnership satisfy the reporting obligation of that election by issuing information returns to each partner, then requiring each partner to make an amended filing. Allowing the IRS to audit the partnership would also avoid the additional two percent interest charge on underpayments required with the Section 6226 election.
Because of the requirements of the various opt-out alternatives, it is unlikely that the IRS will focus on auditing partnerships that do not opt out. For instance, with the Section 6226 push-out election, each of the partners receives an information return showing the amount of income allocated from the audit. Likewise, partnerships opting out completely under Section 6221 must supply the IRS with the taxpayer ID numbers of all of the partners, making it easier for the IRS to collect an assessment.
Despite the potential administrative benefits of not opting out, many partnerships will likely choose to do so either in part or in whole. This is especially true if it is likely that ownership of a partnership will change over time, since the new audit rules in effect impose the tax liability resulting from an audit on those who are partners at the time of the audit - not those who were partners in the year under audit.Also, partnerships with partners that are not in the highest tax bracket will generally find it beneficial to either opt out under Section 6221 or have the partnership pay the tax at their actual tax rate under one of the other elections.
Who makes the decision?The decision to completely opt out must be made annually on the partnership’s tax return. On the other hand, the Section 6226 election to “push out” the tax liability to the partners must be made 45 days after the IRS assessment. At a minimum, a partnership agreement should specify who has the authority to make these decisions and when. If the decision is made to make the annual Section 6221 opt-out election, the partnership agreement should provide for this, with the ability to revisit the decision if a specified percentage of the partners decide to do so. The same procedure could be implemented for the Section 6226 push-out election, with the partnership agreement providing that this election will be made after an IRS audit assessment – unless a specified percentage (presumably more than a majority) of partners decides to not make the election for a particular audit. It is critical that these provisions be added now – once the audit has happened, the partners may have differing interests depending on their ownership status during the year under audit.
Leaving this decision up to the partnership representative would usually not be desirable since he or she may have an interest in the audit procedure used. For instance, if the partnership representative had been a partner in the year under audit, but new partners have been admitted, not opting out under 6221 or not making a Section 6226 election would shift some of the burden of any assessment to the new partners since the tax would be paid out of current partnership assets and not out of the partnership representative’s pocket. The partnership agreement should therefore set forth the procedures for how the partners make this decision and should not leave the decision in the hands of the partnership representative. The agreement should also be clear that if the decision to opt out can be made without the consent of all the partners, that written notice of the decision be given to all of the partners.
A final issue with the Section 6221 opt-out election is that, as discussed above, only partnerships with less than 100 partners all of which are with individuals, corporations, or estates of deceased partners, are eligible. If a qualifying partnership decides to opt out using this election or wants it to be an option in the future, the partnership agreement should contain transfer restrictions to keep a partner from transferring an interest to a non-qualifying partner (such as a trust or another partnership or LLC) that would prevent the partnership from making this election.
Make a plan for your Partnership RepresentativeBecause of the significant authority granted to the partnership representative, every partnership and operating agreement should address the partnership representative’s status, authority and the limitations imposed on the exercise of this authority. It is important to remember that “opting out” of the new audit rules or making any of the elections described above impacts how the partnership is audited and how any additional tax is assessed; it does not mean the partnership is opting out of the rules applicable to the partnership representative.
Partnership representative guidance to include in your partnership/operating agreement:
- The partnership/operating agreement should specify how a partnership representative is elected and removed, and how a replacement partnership representative is chosen. This is especially important given the possibility that a partnership representative could leave the partnership, but still be named the partnership representative. Unlike a TMP, the partnership representative does NOT need to be partner in the partnership.
- The agreement should require that the partnership representative give notice to all of the partners of certain specific events. The extent of the notice required will depend on the relationship between the partners, but at a minimum the partnership representative should be required to give notice of the commencement of an audit, and when any assessment has been made, along with information on options available to appeal the assessment.
- For most partnerships, provisions limiting the authority of the partnership representative will be appropriate. Similar to provisions limiting the authority of an LLC manager, the partnership/operating agreement could require that some percentage of the partners must agree to certain actions to be taken by the partnership representative, such as settling an audit or extending the statute of limitations. It is important to remember that these provisions do NOT alter the authority of the partnership representative from the standpoint of the IRS. The IRS will always view the partnership representative as the sole authority with respect to the partnership. The partnership representative can, however, agree with its partners that decisions will not be made unless certain procedures are followed.
Prepare for adjustments to Distributive Shares.One of the more alarming provisions of the new rules relates to audit adjustments to distributive shares. This happens when the result of the audit is not that the partnership has more overall income, but that the IRS determines that one partner should have been allocated more income (or fewer deductions) than was actually allocated to that particular partner. Under the current rules, this type of audit adjustment would essentially represent a “wash” between the partners as a whole, since an increase in income allocated to one partner implicitly results in a decrease in the income allocated to the other partners.
For example: If John and Dave are partners in AB partnership and the IRS determines that $100,000 of depreciation deductions allocated to John should have been allocated to Dave, John’s income increases by $100,000 – but Dave will have a corresponding decrease in taxable income due to the increased depreciation deduction.
Under the new audit rules, however, this “wash” does not work. The rules specify that if there is an adjustment to the distributive shares amongst the partners, any increase in deductions (or decrease in income) allocable to other partners is ignored. In the example above, the partnership would have a decrease in the $100,000 of deductions and the partnership would owe taxes based on this reduction. One way to fix this problem would be for the partnership to make the “push-out” election. Another fix would be for partners to each file their own amended returns under Section 6225. The key to this working, however, is that all partners must agree to file amended returns. In the example above, John will obviously be reluctant to do this since the amendment will result in higher taxes for him. The partnership/operating agreement therefore should compel all of the partners to file amended returns pursuant to Section 6225 in this situation.
Think ahead to Purchase and Sale IssuesAnother area calling for potential agreement revisions relates to the fact that the adjustment made and tax assessed against the partnership will take place the year the adjustment is made. This means that the tax burden relating to an audit could be imposed on partners who were not the partners that received the benefit of the erroneous income calculation the year that was audited.
Accordingly, partners buying into a partnership will need to be especially careful with the new audit rules. If the partnership has not opted out of the rules, a new partner buying in could essentially be responsible for taxes that relate to a year prior to the purchase – effectively paying a tax liability that was the responsibility of the former partner(s). Because the Section 6226 "push out" election is made only after the assessment, a new partner has no assurance that the partners in the year under review will agree to elect to bear the tax burden of the audit. This issue can be dealt with by contract, either in the partnership agreement or in the purchase agreement for the acquired interest. Some options include:
- The partnership agreement could provide that the partnership has recourse against partners who have left the partnership if a tax is assessed for a year during which they were a partner.
- The partnership agreement could mandate that if there has been an ownership change between the year under audit and the audit itself, that the partnership makes the Section 6226 election to issue amended information returns to those who were partners in the year under audit. These partners must then take the adjustments into account on their own tax returns.
- A partner buying a partnership interest can address the issue in the purchase agreement. A representation from the selling partner or the partnership itself that all tax returns are correct and all taxes have been paid, with indemnification provided for a breach of these representations would be appropriate. While this language is typical in corporate equity sales, in partnership purchase transactions this issue is often not raised since the assumption is that the selling partner would (under the current rules) pay any additional tax relating to an audit of a prior year.
Decide on reconciliation of Revised Tax CalculationsOnce an assessment is made against the partnership, the calculation of the tax due is one of the more complicated parts of the new audit rules. A partnership will have the ability to reduce the tax due by showing that certain partners (tax-exempt organizations, for example) are subject to a lower rate than that used by the IRS in calculating the partnership’s liability. If the partnership does have the assessment reduced because a partner is subject to a lower tax rate, there are many unanswered questions on how the revised assessment affects the burden on the partners for the remainder of the tax liability.
For instance, assume an LLC has two equal members, one is tax-exempt and the other is taxed at the highest tax rate. While the LLC can have the tax on the assessment reduced by demonstrating that one member is not subject to tax, how do the LLC and the individual members take this difference into account? In the absence of the issue being addressed in the operating agreement, the tax-exempt member will essentially still pay for 50 percent of the remaining tax liability since the remaining liability would be paid by the LLC. Partnerships with partners in very different tax brackets should seriously consider either opting out of the new audit rules and have each individual partner pay his or her share of the assessment at whatever tax rate he or she is subject to, or provided for a “true-up” mechanism in the partnership/operating agreement to address this result.