The New Partnership Audit Rules Are Coming!

For the corporate attorneys and accountants who read the headline and asked, "What audit rules?," you may want to pay especially close attention.

What's All the Fuss About?

With the Bipartisan Budget Act of 2015 (BBA), Congress repealed the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). Why is this important? TEFRA set forth the old rules governing audits of all entities taxed as partnerships (that includes most multi-member LLCs). Under the old rules, each partner would effectively be audited individually. So while a designated "Tax Matters Partner" would be the point of contact for the audit, each partner had a right to participate in the audit and receive notice of all the proceedings from the IRS. Any adjustments upon audit were made on each partner's return, and any interest, penalties, and statutes of limitation were also evaluated based on each individual partner. All this sounds fair, right? Sure, at least from the taxpayers' point of view... but audits of partnerships became such a pain in the ass for the IRS that partnerships almost never got audited. Imagine what it was like for the IRS auditing the individual members of a hedge fund or private equity LLC, one which was only a small part of a complex web of entities beneficially owned by hundreds of individuals across the globe.

The BBA changed all that. New rules now apply to partnership audits for all taxable years starting after December 31, 2017. The American Bar Association Section of Taxation wrote an eloquent appeal to the House Ways and Means and Senate Finance Committees urging them to delay effectiveness of the new rules for one more year. Will they successfully persuade Congress? Maybe, but don't count on it.

In five presentations about these audit rules to mid-size and small firm CPAs over the last year, I asked the listeners to raise their hands if they had ever seen a client's IRS Form 1065 get audited. Between all five audiences, only two hands ever went up. You'd better believe those numbers are going to change dramatically once the changes kick in.

How do the new rules work? Partnerships are now audited as a unit. Partners have no right to participate in the audit or receive notice of any proceedings from the IRS. The point of contact is now a "Partnership Representative" rather than a "Tax Matters Partner," and this Partnership Representative has almost absolute power to conduct the audit -- including the power to reach an agreement with the IRS to which every partner is bound with no chance to mount a partner-level defense.

Adjustments (including interest, penalties, and statutes of limitation) are now evaluated at the partnership level, not at the partner level. Any underpayment is assumed to pass through to the partners at the highest individual rate (currently 39.6% for federal income tax) unless the partnership can prove the IRS should use a lower rate. When the adjustments are made, they're passed through to the partners during the year of the adjustment, not the year under audit!

Example: Huey, Dewey, and Louie are partners of the Duck Tales Partnership in 2020. In 2022, Huey sells his partnership interest to Launchpad McQuack. In 2023, prior to the expiration of the statute of limitations, the IRS audits the Duck Tales Partnership's 2020 IRS Form 1065. The IRS adjusts income upward and passes through the extra income to the Duck Tales Partnership's partners in 2023. What does that mean? Launchpad pays income attributable to a year in which he wasn't even a partner -- Huey was the partner during that year instead of him! Tough luck for Launchpad -- he pays the tax for the adjustment while Huey skates with no liability. Crazy outcome? You bet -- but that's how these new rules work.

Here are some other key facts you should know about the new rules:

• "Opt-Out" Election: If you and your clients hate the new rules, there might be hope -- Congress allowed certain partnerships to "elect out" of the BBA regime and effectively go back to the old rules. This election must be filed every year with notice to each partner. I know what you're thinking: "Okay, everyone will do this, so we're home free, right?" Not so fast: this election can only be made by partnerships whose partners are only (1) corporations (either subchapter C or S), (2) individuals, or (3) estates of deceased individuals. That means any partnerships whose partners include other partnerships, trusts (yes, even grantor trusts, according to the Regulations), not-for-profit organizations, employee benefit plans, and even single-member LLCs (disregarded entities) will not be eligible.
• "Push-Out" Election: Recall the example with poor Launchpad McQuack. Why is he caught up in paying taxes for a partnership tax year in which he wasn't even a partner? Congress considered this scenario and allowed all partnerships to elect to "push out" adjustments to the partners of the partnership during the audit year in question. So in the prior example, if the Duck Tales Partnership makes this election, the 2020 tax year adjustments are "pushed out" to Huey, and Launchpad is no longer on the hook for taxes in a year when he was not a partner. I know what you're thinking: "Okay, every partnership will make this election, right?" Maybe not -- interest is charged at a rate 2% higher than normal, and any "old" partners receiving a "pushed out" adjustment (like Huey in our example) have no defense or right to review, so they are automatically liable.

What Does This Mean for Me and My Clients?

The question that's probably on your mind after reading all this: What do we do now!? Clearly, partnership agreements and LLC operating agreements will need to be amended, and corporate transactions will need to be negotiated differently. Here's a non-exclusive list of things to do and watch out for:

Designate a Partnership Representative

The obvious reason this is important is the immense power afforded to a Partnership Representative (PR) under the new rules. The not-so-obvious reason is because if a partnership hasn't designated a PR, the IRS can designate a PR for it. Better yet, the PR need not even be a partner, so the IRS can designate any person with a substantial presence in the United States. Among the items that will need to be negotiated between the partners:

• Required notice to the other partners of all the PR's actions
• The extent of the PR's authority to take certain actions without the consent of the partners
• The requirements to make "opt-out" or "push-out" elections
• The mechanism to revoke the PR designation or remove the PR
• Exoneration of the PR from liability

Importantly, while the "boilerplate" tax language used to work under the old rules, the new rules require customization of the PR provisions for each partnership.

Figure Out Procedures for Making Elections and Dealing with Adjustments

• Should an "opt-out" or "push-out" election be automatic?
• Should the partnership think about specially allocating adjustments (if Section 704 of the Code would even allow it)?
• Should old partners have a say in whether a "push-out" election is made?
• What if the adjustment is actually a benefit - should a "push-out" election be automatic in that case?
• What requirement will the partners have to provide information to the PR upon request for the purpose of, e.g., proving adjustments should be made at a lower tax rate?
• What happens if a partner is dead or (in the case of an entity) dissolved by the time the adjustment occurs?

Factor in the New Rules when Negotiating Corporate Transactions

This is where most traps for the unwary will lie. In talks for mergers, divisions, purchases, sales, and other similar transactions, the parties must consider issues like:

• How should future tax liabilities be allocated between the parties? Should the seller have a say in a push-out election? Should the seller have a say in other issues, such as voting on whether the PR can reach an agreement with the IRS?
• Should there be escrows, clawbacks, or indemnifications in the event future tax liabilities have a material impact on the transaction? Note that these may have their own tax effect -- for instance, indemnification payments might be considered taxable income.
• What impact should these new rules have on due diligence?
• Do form documents need to have a brand new set of representations and warranties for taxes?

Get Your Accounting Records in Order

If you're an accountant, the last thing you want upon an audit is for the field agents to discover you either haven't been tracking key tax attributes or you've been accounting for them incorrectly. Be sure you can quickly and confidently answer questions about the following items:

• Capital Accounts - the IRS may ask for a history of how the balances became the way they are.
• Profit/loss (Section 704(b)) Allocations - these should follow the partnership's governing agreement exactly. Do these allocations meet a regulatory safe harbor? If not, do the allocations have substantial economic effect?
• Inside and outside basis - yes, they're different; yes, you need to track both.
• Inside and outside holding period - ditto.
• Mixing Bowl (Section 704(c)) Allocations
• Partner Shares of Liabilities and Minimum Gain
• Partner Shares of "Hot Assets" and Section 1245 and 1250 Recapture
• Contributions and Distributions - for tracking possible "disguised sales"

Unanswered Questions About Interactions with States

The BBA only applies to federal audit procedures. I practice in New York State -- to my knowledge, New York State has not changed its own administrative procedures to match the federal government. The actual tax consequences of a federal audit would trickle down to the states, but administrative processes would not match.

Information sharing would likely become more efficient in light of these rules, and a federal audit might almost automatically lead to a state audit. The reverse might also become true.

Consider what happens when a partner changes residency or domicile between the taxable year under audit and the date the audit concludes. Can a state constitutionally claw back the adjustment? That's an open question subject to serious debate. Another constitutional question to consider would be how these audit rules impact apportionment. The state and federal courts will undoubtedly decide the outcome of these thorny issues once the audit rules are effective.

The Time Is Now!

Making required amendments to governing agreements, deal paperwork, and other key documents will take time and effort. Don't save the heavy lifting until it's too late and the stakes are too high. As the summer concludes and work kicks back into high gear, addressing the impact of the new partnership audit rules must be a priority on your to-do list.