In 2015, The Bipartisan Budget Act (BBA) introduced new partnership audit and adjustment procedures for tax years beginning after December 31, 2017. These rules are important to understand as they continue to hold potential impacts on prior year tax adjustments as well as affect current year economics for your tax-exempt organization.
The BBA, signed into law on November 2, 2015, completely replaced the previous partnership audit and adjustment regime generally known as the TEFRA rules. Under the TEFRA rules, partners, and not the partnership, were 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, which were in effect for more than 30 years, generally covered state law entities classified as partnerships for federal tax purposes. Partnership audits and adjustments under the TEFRA rules were a mix of items determined at the partnership and partner level. A tax matters partner (TMP) appointed by the partnership had certain responsibilities relating to any partnership engagement with tax authorities, but other partners also had rights to participate in examinations and to individually protest.
Importantly, under the TEFRA rules, partners, and not the partnership, were 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% 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.
Administrative Adjustment Requests
If a partnership wants to change the way something was reported on its original return, a partnership subject to the new BBA rules cannot file an amended return. Instead, it files an Administrative Adjustment Request or AAR. If the request results in an imputed underpayment, the partnership can either pay the amount due or push it out to the partners. If the request results in a favorable adjustment, the adjustment must be pushed out to the partners and claimed on their own tax returns.
The push out rules for AARs are like the push out rules for tax adjustments that stem from an IRS audit. If the partnership makes an AAR in the year 2021 to their 2018 tax return, the partnership or partners pay the imputed underpayment in 2021 or take any adjustments into account on their 2021 tax returns.
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 it is not required that this person 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.
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.
Exempt Organization Considerations
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
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