Need for a change
On November 2, 2015, the Bipartisan Budget Act was passed, changing how partnerships will be audited by the Internal Revenue Service (IRS) for years beginning after December 31, 2017. Taxpayers can adopt the new rules earlier for tax years starting after the Act was passed. Instead of audit adjustments being assessed on a per-partner basis, they will now be determined and collected at the partnership level.
The Joint Committee on Taxation estimates the change will result in $9.3 billion of taxes collected over ten years. This may be true as partnership audits in the past have been challenging, requiring the IRS to go after hundreds or thousands of partners to collect on their adjustments, if the partnership did not elect to be taxed at the entity level (which few do). Complex multi-tiered partnership structures and allocation methods, as well as lack of automated procedures at the IRS, burdened the audit process further. Such limitations kept the IRS from putting resources into auditing partnerships:
- From 2007 to 2012, the IRS audited less than one percent of partnerships with assets in excess of $100 million (except for 2010 when the rate rose to 1.4 percent).
- During the same timeframe, they audited 20.6 percent to 27.1 percent of corporations with a similar asset-sized threshold.
- Partnership audits were less effective than corporate audits – 64 percent of large partnerships audited in 2013 had no changes to reported income or loss, whereas only 21 percent of corporations during that year netted the same no change result.
It is expected this will change. Beyond the federal level, many expect states will soon pass similar rules.
The Tax Matters Partner concept created by the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) will be replaced by a Partnership Representative who will have the sole authority to bind the partnership and its partners in these audits. This may be a partner or anyone else with a substantial presence in the United States. Historically, the IRS spent a lot of time determining the Tax Matters Partner. Under these new rules, the IRS can appoint a Partnership Representative if one has not been identified by the partnership. Also, it seems partners will no longer participate in audits, will not have to be notified regarding audit developments, and may not be able to contest the results.
The IRS will now examine a partnership's return for a particular partnership year ("Reviewed Year"). Any adjustments to the Reviewed Year will be taken into account by the partnership rather than the individual partners. The IRS will give a Notice of Proposed Partnership Adjustment calculating an imputed underpayment that will need to be paid by the partnership in the “Adjustment Year.” Consequently, new partners may essentially be paying taxes on income attributable to departed partners.
Any modification not resulting in an imputed underpayment will be taken into account by the partnership in the Adjustment Year as a reduction or increase in a non-separately stated income or loss, respectively; or, in the case of a credit, as a separately stated item. The partnership will have the option to demonstrate that the adjustment would be lower if the adjustment was based on certain partner-level information, such as a partner's marginal tax rate.
In lieu of making the adjustment at the partnership level, the partnership may issue adjusted Schedules K-1 to the Reviewed Year partners who would take the adjustment into account in the Adjustment Year through a simplified amended-return process.
Additionally, the Act requires that each partner treat each item of income, gain, loss, deduction, or credit attributable to a partnership in a manner that is consistent with the treatment of such item on the partnership return. Under the Act, the IRS may treat any underpayment of tax by a partner by reason of inconsistent treatment as a mathematical error on the partner's return, unless the partner attaches a statement that notifies the IRS of the inconsistency (Form 8082).
The imputed underpayment includes all tax, interest, and penalties netted together. It is calculated by using the highest applicable federal tax rate (currently 39.6 percent) on all income. If part of this adjustment involves reallocation of income from one partner to another, only the tax increase (and not the net) is included, meaning the same income could be taxed twice.
Of interest to investment partnerships: this adjustment does not take into account character of the income adjustment, only its net effect. This will be especially important to partners in so-called investor partnerships as deductions from partnerships classified in this manner (which is determined based on their trading strategy’s turnover) are generally taxed as miscellaneous itemized deductions subject to the 2 percent Adjusted Gross Income (AGI) floor for regular tax and disallowed for those in Alternative Minimum Tax (AMT). It also appears that if the IRS contended the partnership should be classified as investor and not as trader (trader deductions are generally deducted “above the line” by individual partners, meaning they are not subject to the 2 percent AGI floor or to AMT limitation), this imputed underpayment would not apply, since classification as a trader or investor only affects the character of the deductions and not their amount.
Once the Notice of Proposed Partnership Adjustment is issued, the partnership has 270 days to respond. It may be able to reduce the imputed underpayment by showing some of the income increase is allocable to a “tax-exempt” partner (which includes foreign entities or individuals), a C corporation (which currently has a slightly lower tax rate than individuals at 35 percent), or is to an individual and attributable to long-term capital gains or qualified dividends.
After this is resolved, the partnership has three options:
- Pay the tax, interest, and penalties on the imputed underpayment (which is not a deductible expense – similar to an individual’s payments of federal income tax not being deductible on its return). Current partners will bear the economic burden of this expense.
- Elect within 45 days of the IRS’ Notice of Final Partnership Adjustment to furnish a statement to the reviewed year partners detailing their share of any adjustments, so they can pay their share in the adjustment year, not in the reviewed year. The IRS will charge 2 percent higher interest for this option.
- File an Administrative Adjustment Request (AAR) (essentially an amended return) for any partnership taxable year (within a three-year statute of limitations). Underpayments in tax will be due at the partnership level when the AAR is filed, but can be passed through to the partners if the same type election from above is done. Overpayments of tax have to be passed through as additional deductions by the partners.
Exclusions to new rules
Electing out of these new rules, which must be done annually with a timely filed tax return, is available to a partnership with less than 100 partners all of whom are individuals, C corporations, foreign entities that would be a C corporation if they were domestic, estates, or S corporations (each shareholder of an S corporation, however, counts towards the 100). As for disregarded entities such as a single member LLC, some attorneys believe one being a partner would prevent this election being an option. There are opposing views on the impact of grantor trust partners on this election. Problems would obviously arise if partners transfer their interest to a non-eligible entity as well.
Unanswered questions and possible solutions
There are many unanswered questions at this point.
- If the partnership under audit ceases to exist before the reviewed year, adjustments are passed through to the former partners. However, what happens if some of those partners are partnerships that also have dissolved?
- In a tiered structure, does it keep flowing down and what effect does that have on the elections where the tax is passed down?
- What happens if partnership interests change multiple times during the year (as in Publicly Traded Partnerships or Master Limited Partnerships)?
- Is this relevant if a trader investment partnership has made an Internal Revenue Code Section 475(f) election for all of its securities to be marked to market each year for tax purposes and, therefore, there are no unrealized gains or losses from year to year?
- If an investment partnership uses stuffing or a fill-up/fill-down provision to allocate its realized gains and losses each year to departing partners with cumulative unrealized gains or losses to essentially have no realized gain or loss on their disposal of their partnership interest, will there really be much of an impact on existing partners from the underpayment of tax by the partnerships in prior years?
- What will be the impact on the financial statements – will more detailed and costly analysis of tax positions need to be done to prevent the booking of tax liabilities?
Attorneys and accountants are exploring potential strategies to mitigate any negative impacts. Some of the solutions offered:
- Issue side letters indemnifying old partners if an imputed underpayment is levied within the statute of limitations
- Reduce partnership size to allow electing out of the rules or to only have related partners
- Restrict transfers of partnership interests
- Structure general partner entities that receive the carry/incentive allocation as S Corporations to allow election out of these rules
How investor partnerships in their early years will grow with these new restrictions will be just one more of the numerous challenges they face already.
As the date these new rules become effective approaches, we expect more developments. Partnerships should monitor these changes and discuss the potential impacts with their tax advisor.
For more information on this topic, or to learn how Baker Tilly tax specialists can help, contact our team.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.