The Bipartisan Budget Act of 2015 (BBA) introduced new partnership audit and adjustment procedures for tax years beginning after December 31, 2017, that represent a dramatic change and could result in prior year tax adjustments altering current year economics.
The BBA, signed into law on November 2, 2015, completely replaces the current partnership audit and adjustment regime generally known as the TEFRA rules. Under the TEFRA rules, partners, and not the partnership, are responsible for any tax liabilities stemming from an audit or adjustment at the partnership level. In contrast, the default rule under the BBA results in the partnership, and not the partners, paying the tax.
The TEFRA rules, in effect for more than 30 years, generally cover state law entities classified as partnerships for federal tax purposes. Partnership audits and adjustments under the TEFRA rules are a mix of items determined at the partnership and partner level. A tax matters partner (TMP) appointed by the partnership has certain responsibilities relating to any partnership engagement with tax authorities, but other partners also have rights to participate in examinations and to individually protest. Importantly, under the TEFRA rules, partners, and not the partnership, are responsible for paying any tax liability (or claiming any refund) resulting from an audit or adjustment.
Partnership structures are increasingly complex, with large numbers of partners investing through tiers of entities. This has made it difficult for the IRS to effectively administer the partnership tax rules. The IRS often struggles to identify the individual or entity ultimately responsible for any tax. And the limited rights afforded to the TMP, along with the rights to intervene afforded to all partners, produces long and complex procedural arguments. As a result, the Government Accountability Office estimates less than 1 percent of large partnerships were audited to completion for the 2012 tax year.
The BBA Rules in General
The new BBA rules represent an attempt by Congress to make it easier for the IRS to audit partnerships. The default rule is that a partnership, and not its partners, pays any tax resulting from an adjustment. Moreover, the partnership pays any tax liability resulting from an adjustment in the current year, not the year under audit.
For example, if the IRS makes an adjustment in the year 2021 to a partnership’s 2018 tax return, and the partnership is subject to the default rules, the partnership pays the tax liability in 2021. This results in an economic burden for the partners owning interests in the partnership in 2021 even if those partners did not own an interest in 2018. The adjustment is generally referred to as an “imputed underpayment” and is calculated based upon the highest applicable tax rate, although the tax profile of certain partners can be taken into account to reduce this rate. Applicable penalties are also determined at the partnership level.
A partnership with 100 or fewer partners can elect out of the BBA rules with an annual election filed with a timely tax return, provided all partners are individuals, C corporations, S corporations, or estates. If one of the partners is an S corporation, the total number of shareholders of the S corporation counts toward the 100-partner limit. Partnerships with either a partnership, trust or disregarded entity as a partner cannot elect out under the current BBA rules. An election to opt out of the BBA rules means that the IRS must open up an exam for the ultimate taxpaying partner and make any adjustments, partnership-related or otherwise, at that taxpaying partner’s level. Eligible partnerships likely will make the election to opt out, absent unique circumstances.
Electing to Push Out the Tax Liability
To avoid the default treatment, a partnership can elect to push out any tax adjustment to its partners. This election must be made no later than 45 days after the date of an IRS notice of final partnership adjustment. Once an election is made, the partnership furnishes a statement to each partner owning an interest in the year of the adjustment, calculating any additional tax liability. Those recipient partners do not have to file an amended return.
In the prior example, where a partnership is audited in 2021 for its 2018 tax year, the push-out results in statements being sent to each partner owning an interest in 2018. Multiple adjustments over several years can be netted together. Congress (through amendments to the BBA rules) and the IRS (through regulations) have provided rules allowing a partnership ("upper-tier partnership") that is itself a partner in another partnership ("lower-tier partnership") to also make the push out election for any adjustments flowing from the lower-tier partnership.
The new BBA rules replace the role of the TMP with a new role called the Partnership Representative. Unlike the TMP, the Partnership Representative has significant authority to settle tax disputes and bind a partnership, without notification or significant rights afforded to other partners, and is not required to be a partner. Like the default rule of a partnership level tax, this new role of the Partnership Representative is a large change, and partnerships will need to carefully consider the identity of the Partnership Representative and what types of protections the other partners may want to include in any partnership agreements.
Although the BBA rules are effective for tax years beginning after December 31, 2017, partnerships can make an election to adopt the new rules early for tax years beginning after November 2, 2015. The election must be filed within 30 days of receiving an IRS notice and the election is binding. The IRS issued temporary regulations covering the early election.
State Law Considerations
It is unclear at this point whether states will adopt rules similar to the new BBA rules. States with conforming statutes may use the new rules, but other states may choose to adopt only portions of the new rules or none at all.
The new BBA rules represent a dramatic change from the TEFRA rules. Under these new rules, an IRS adjustment can directly impact the current year economics of a partnership, even for partners who did not own an interest in the taxable year of the adjustment. Prospective partners may need to perform increased diligence or ask for protective provisions in order to guard against any prior year tax liabilities. Partnerships may also need to consider how uncertain tax positions could affect financial reporting obligations.
Current action points all partners and partnerships should think through include:
The IRS has released several batches of regulations implementing the new BBA rules and Congress passed technical corrections to the BBA on March 23, 2018. Future statutory and regulatory updates may further modify these new rules. You should continue to monitor this changing landscape.
Contact your Eide Bailly professional or Adam Sweet (firstname.lastname@example.org; 509.252.4019), Eide Bailly passthrough consulting
director, with questions related to the new rules and how they impact your business.
The information contained in this article is general in nature and is not intended as legal, accounting or other professional advice. Readers should seek legal, accounting or other professional advice regarding their particular factual situation.