March 25, 2019
The Bipartisan Budget Act of 2015 introduced new partnership audit and adjustment procedures for tax years beginning after Dec. 31, 2017, that could directly affect a tax-exempt partner’s economics in the event of an IRS audit. These rules were designed to make it easier for the IRS to audit partnerships. Under the Bipartisan Budget Act 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. For example, an IRS adjustment to a partnership’s net income could result in more unrelated business income being allocated to a tax- exempt partner in a current year even if that tax-exempt partner did not own an interest during the year under audit. Under the prior rules, partners, not the partnership, were responsible for any tax liabilities stemming from an audit or adjustment at the partnership level.
If a partnership wishes to avoid the new default audit rules, it can either opt out of the Bipartisan Budget Act rules, if eligible, or the partnership, at the conclusion of an IRS audit, 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 versus the year of the adjustment.
You can read our insight, New Partnership Audit Rules Raise the Prospect of IRS Audit Affecting Partnership Economics, for an in-depth overview of these new rules.
Considerations Before Entering a Partnership
Under the new Bipartisan Budget Act 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 could insist on indemnification protection should an IRS audit for a prior year result in a partnership level tax adjustment 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. 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 tax audit adjustments. As an alternative to the indemnification, a tax-exempt partner could request that the designated partnership representative for tax matters make the push out election, so that the partners owning the interest in the year audited, bear the tax burden of any 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 Bipartisan Budget Act rules, a partnership subject to the default rule 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 can 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. Failure to consider the presence of a tax-exempt partner and adjust the tax rate or allocations could result in the tax-exempt partner being deemed to indirectly subsidize other non-tax-exempt partners, causing concern of private benefit.
Protect Your Organization
If your tax-exempt organization is invested in a partnership, and the partnership chooses to be subject to the default rules, consider what types of indemnification provision, or other contractual protections, you may want to explore for the protection of your organization. If the partnership decides to opt out or make the push out election, your organization should ensure it has sufficient financial detail in your organization’s books and records, to substantiate the amounts allocated by the partnership in an IRS audit.
Please contact your Eide Bailly tax professional with any questions related to the partnership audit rules.