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Editorial 7 MIN READ

Ten months until the new partnership audit regime

The Bipartisan Budget Act of 2015 replaced TEFRA, takes effect for tax years beginning after December 31, 2017, and almost no operating agreement on file anticipates it

The Editors
Staff, Incorporator.org
7 min read Updated
Contents 7 sections
  1. What the law actually does
  2. The partnership representative
  3. The election out, and who can use it
  4. The push-out election under § 6226
  5. What the operating agreement has to decide
  6. The regulations, and why you cannot wait for them
  7. Sources

very partnership and LLC taxed as a partnership has a little over ten months to decide who its "partnership representative" is, whether it qualifies to elect out, and what its operating agreement should say about an audit the IRS has not yet started. The Bipartisan Budget Act of 2015 rewrote the rules for how the IRS examines partnerships, and the new regime applies to partnership tax years beginning after December 31, 2017.

The statute has been on the books since November 2015. Proposed regulations were published in the Federal Register in January. They were pulled nine days later under the new administration's regulatory freeze. None of that changes the effective date.

What the law actually does

Section 1101 of the Bipartisan Budget Act of 2015 (Pub. L. 114-74, Nov. 2, 2015) repealed the TEFRA partnership audit procedures and the separate electing-large-partnership regime. In their place it enacted a new subchapter C of chapter 63, codified at IRC §§ 6221 through 6241. The Protecting Americans from Tax Hikes Act of 2015 (Pub. L. 114-113, Dec. 18, 2015) made technical corrections weeks later. The combined result is a single, centralized audit, adjustment, and collection regime that runs at the partnership level by default.

The mechanical change is this: under TEFRA, the IRS audited a partnership, determined adjustments, and then assessed each partner individually for their share of tax. That took years of cross-referencing and produced a well-documented collection shortfall, which the Government Accountability Office had flagged repeatedly and which was the stated congressional justification for the overhaul. Under the new regime, the IRS audits the partnership, computes an "imputed underpayment" under § 6225, and collects that underpayment from the partnership itself in the year the audit closes — the "adjustment year" — at the highest rate of tax in effect for the reviewed year. The economic partners who bear the hit are the partners in the adjustment year, not necessarily the partners who were there during the audited year. That mismatch is the single most important operational fact in the statute, and it is the reason partnership agreements need new language.

The partnership representative

Section 6223 replaces the TEFRA "tax matters partner" with a "partnership representative." The representative need not be a partner. It can be any person (including an entity, subject to forthcoming rules requiring a designated individual to act through it) with a substantial presence in the United States. The representative has sole authority to act for the partnership in dealings with the IRS under the new regime, and the partnership and all partners are bound by the representative's actions and decisions. Under § 6223(b), partners have no statutory right to notice from the IRS, no right to participate in the examination, and no right to opt out of a settlement the representative signs.

This is a concentration of authority the TMP never had. In TEFRA a partner could, in the right circumstances, file a notice to receive IRS correspondence and participate in proceedings. Under the new regime that machinery is gone. Whatever the partners want their representative to be required to do — consult them, seek consent before settling, stand down in a conflict — must be in the operating agreement, because it is not in the Code.

The election out, and who can use it

Under § 6221(b), a partnership with 100 or fewer partners during the taxable year may elect out of the centralized regime for that year, provided every one of its partners is an "eligible partner." Eligible partners are individuals, C corporations, foreign entities that would be treated as C corporations if domestic, S corporations, and estates of deceased partners. For purposes of the 100-partner count, each shareholder of an S corporation partner is counted separately.

The list of who is not eligible is the point. Partnerships cannot have partner-level partnerships, trusts (including grantor trusts, including revocable living trusts), disregarded entities, nominees, or estates that are not estates of a deceased partner. A fund-of-funds structure is out. A family partnership with a trust partner is out. A joint venture where one side holds through a single-member LLC is out unless the LLC's owner is named directly. The election is annual, must be made on a timely-filed return, must include the name and TIN of each partner, and requires the partnership to notify each partner of the election within thirty days.

The election out does not revive TEFRA. It drops the partnership into the pre-TEFRA, partner-by-partner deficiency procedures. That is an improvement over the new regime for many small partnerships, but it is not free: the IRS can examine each partner's return separately, and the partnership-level consolidation that sophisticated partnerships sometimes prefer is gone.

The push-out election under § 6226

For partnerships that cannot or do not elect out, § 6226 provides an alternative to paying the imputed underpayment at the partnership level. Within 45 days after the IRS mails a notice of final partnership adjustment, the partnership may elect to "push out" the adjustments to the partners who were partners in the reviewed year. Those partners then take the adjustments into account on their own returns for the year that includes the date the statement is furnished, and they pay the resulting tax, interest at the partnership-examination rate under § 6226(c) (LIBOR-ish plus five rather than plus three), and penalties.

The push-out pulls the economic incidence back to the reviewed-year partners, which is usually what the partners would have wanted. Two features limit it. First, the interest rate is two percentage points higher than the normal deficiency rate. Second, under the statute as enacted, the push-out does not cleanly flow through upper-tier partnerships — an issue Congress was on notice about and which the proposed regulations attempted to address. The technical-corrections legislation that trade groups have been asking for has not passed.

What the operating agreement has to decide

Every partnership and multi-member LLC taxed as a partnership has to make five decisions before its first tax year beginning on or after January 1, 2018. Who is the partnership representative, and if it is an entity, who is the designated individual. Whether the partnership will elect out annually when eligible, and whether the agreement will prohibit admitting ineligible partners (trusts, partnerships, disregarded entities) that would break eligibility. Whether the representative must consult or obtain consent before settling, and what the remedy is if they don't. Whether the partnership will elect push-out under § 6226, and who pays the interest differential. And how the economic burden of a partnership-level payment is allocated when the adjustment-year partners are not the reviewed-year partners — through mandatory indemnities, clawbacks from departed partners, or capital-account adjustments.

None of this is hypothetical drafting. The statute is self-executing. A partnership that does nothing will, as of its first 2018 tax year, have no designated representative until one is chosen on the return, will be subject to the default partnership-pays rule, and will have no contractual mechanism to push economic responsibility back to the correct partners.

The regulations, and why you cannot wait for them

Proposed regulations under the new regime were published at 82 Fed. Reg. 5925 on January 18, 2017. Two days later the White House issued a regulatory-freeze memorandum directing agencies to withdraw rules sent to the Federal Register but not yet published, and to consider postponing those already published. The proposed BBA regulations were withdrawn from the Federal Register before formal publication was complete. Treasury has said it intends to re-propose. As of this writing there is no operative proposed regulation text, and no one outside Treasury knows whether the re-proposal will match what was pulled.

The statute, though, is not contingent on regulations. The effective date sits in section 1101(g) of the Budget Act itself, and no agency action is required to trigger it. For any partnership formed or re-papered in 2017, the responsible drafting assumption is that the new regime applies on schedule and the operating agreement has to handle it without help from Treasury.

The optimistic read is that the re-proposed regulations will clarify the push-out mechanics for tiered partnerships and will formalize the designated-individual rule for entity representatives before the 2018 filing season. The pessimistic read is that partnerships will be drafting to a statute whose implementing rules are still in notice-and-comment when the first adjusted returns start arriving.

Sources

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