Considerations for Tax Exempts Under the New Partnership Audit Rules

December 12, 2017 | Article

The Bipartisan Budget Act of 2015 (BBA) introduced new partnership audit and adjustment procedures for tax years beginning after December 31, 2017 that could directly effect a tax exempt partner’s economics in the event of an IRS audit.  Under the new BBA rules, if the IRS makes an adjustment to a partnership return, the default treatment is a partnership level tax paid with the partnership’s current year dollars.  Under the current rules, an adjustment to taxable income would be allocated back to the partners who were partners during the tax year with the adjustment.  If a partnership wishes to avoid the new default audit rules, it can either opt out of the BBA rules, if eligible, or the partnership can make an election to “push out” any IRS adjustment to the partners owning an interest in the partnership for the tax year under audit (consistent with prior treatment). An in depth discussion of the new BBA rules is beyond the scope of this insight, but please see the recent Eide Bailly insight, New Partnership Audit Rules Raise the Prospect of IRS Audit Affecting Partnership Economics, for an overview of these new rules. 

Under the new BBA rules, tax exempt partners will need to carefully consider what types of protections they may require before entering into a partnership.  For instance, a tax exempt partner buying an interest from another partner may insist on indemnification protection should an IRS audit for a taxable year before the tax exempt investor’s purchase result in a partnership level tax liability for income that would be taxable to that tax exempt partner (such as unrelated business taxable income).  Such protection could require the selling partner to make payment to the tax exempt partner in the event of an IRS adjustment.  Or, a tax exempt partner could require that a partnership make certain adjusting payments after an IRS audit so that the tax exempt partner is not economically harmed by any adjustments.  Alternatively, a tax exempt partner could ask that a partnership manager make the push out election so that the prior year partner bears the burden of the IRS adjustment.

Partnerships and tax exempt partners should also consider how the tax exempt partner’s status may affect the overall amount of any IRS adjustment.  Under the new BBA rules, a partnership pays an “imputed underpayment” as a result of an IRS adjustment, and this underpayment is generally calculated based upon the highest federal tax rate.  However, partnerships are allowed to reduce this rate if the partnership can demonstrate to the IRS that it has a tax exempt partner that would not pay tax based upon the highest federal rate.  This ability of a tax exempt partner to reduce the overall imputed underpayment may make it more palatable for a partnership to agree to certain protections in favor of a tax exempt partner in the event of an IRS adjustment.

Given the implementation of these new BBA rules, Eide Bailly recommends that at all tax exempt partners:

  • Determine whether partnerships will opt out of the new BBA rules, be subject to the default rules, or make the push out election
  • Consider what types of indemnifications, or other contractual protections, to enter into between the tax exempt partner and the partnership and/or any other former or current partners
  • Review current agreements to determine what amendments are needed to conform with the new BBA rules.

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Exempt Organization Tax