New Audit Regime Allows IRS to Assess and Collect Tax at the Partnership Level SUMMARY The Bipartisan Budget Act of 2015 (the Budget Act) replaces the current partnership audit procedures with a very different procedural regime. Under the current procedures, the Internal Revenue Service (IRS) audits partnerships at the partnership level, but the IRS is required to flow any audit adjustments through to the partners who are ultimately liable for any tax due. According to IRS Commissioner John Koskinen, inefficiencies in the current partnership audit procedures make the process very difficult for the IRS. For these reasons, the Commissioner has stated that the IRS audits very few large partnerships. Under the new regime, the default rule provides that the IRS will assess and collect tax, penalties, and interest attributable to audit adjustments at the partnership level instead of the partner level. To avoid that result, a partnership can elect to pass the liability to the partners during the tax year to which the IRS adjustment relates. While this alternative procedure achieves a similar result as the current partnership audit procedures, the key difference is that the partnership rather than the IRS must determine how to flow the audit adjustments through to its partners, and the partnership must report these adjustments to its partners and the IRS. The new partnership audit procedures are effective for tax years beginning on or after January 1, 2018, although partnerships may elect to apply the provisions sooner. The procedures are intended to reduce the IRS s difficulty in auditing partnerships, which should in turn increase both the number of partnership audits and the amount the IRS ultimately collects from those audits. The Congressional Joint Committee on Taxation estimates that this change in audit procedures will result in approximately $9.3 billion in additional revenue over ten years. The new procedures likely will also affect the way future partnership agreements are drafted and negotiated. New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney www.sullcrom.com
DISCUSSION Most partnerships are currently subject to audit rules adopted as part of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). 1 Under these rules, the IRS conducts a single examination at the partnership level. 2 If the IRS makes an adjustment, the partners during the tax year to which the adjustment relates are responsible for paying any tax due. Before that can happen, however, the IRS must undertake what, according to the IRS, is a time- and labor-intensive process to flow the adjustment through to the partners. This can be especially complicated for partnerships with many partners and for partnerships in tiered structures where the IRS has to flow adjustments up through several levels before reaching the ultimate partners. For example, if a partnership understates its taxable income by $10 million but has 10,000 partners, the IRS could potentially have to assess and collect tax attributable to $1,000 of income from 10,000 different taxpayers. A 2014 report by the United States Government Accountability Office found that the TEFRA audit procedures and the growing complexity of large partnership structures hinder the IRS s ability to effectively audit large partnerships. 3 According to that report, in 2012 the IRS audited only 0.8% of large partnerships compared to 27.1% of large corporations. 4 IRS Commissioner Koskinen has likewise acknowledged that the [a]uditing of large partnerships has become a very challenging area for the IRS, in part because the number and complexity of partnerships has grown significantly over the last several years, and also because of inefficiencies in the partnership audit rules.... 5 In this regard, the Commissioner explained that having to follow the TEFRA procedures is now more of a burden for the [IRS] than a help. 6 1 2 3 4 5 6 See I.R.C. 6221-6234 (repealed for tax years beginning on or after January 1, 2018). Where the statutory provisions in the Budget Act overlap with the TEFRA statutory provisions, this memorandum uses TEFRA and Budget Act parentheticals to distinguish one from the other. I.R.C. 6221 (TEFRA). In the case of certain partnerships with ten or fewer partners, the TEFRA audit procedures do not apply. See I.R.C. 6231(a)(1)(B) (TEFRA). Instead, the IRS must issue a separate audit report to each partner and each partner can then act independently to challenge its own audit report under the deficiency procedures that otherwise apply to individuals. See, e.g., I.R.C. 6213. United States Government Accountability Office, Large Partnerships: Growing Population and Complexity Hinder Effective IRS Audits 13-17 (July 22, 2014). Id. at 10. Written Testimony of John A. Koskinen, Commissioner, Internal Revenue Service, Before the Senate Finance Committee on IRS Budget and Current Operations 7 (Feb. 3, 2015). Id. -2-
Against this backdrop, the Budget Act repeals the TEFRA audit rules and replaces them with a new set of partnership audit procedures. 7 The new procedures apply to partnership tax years beginning on or after January 1, 2018, but a partnership can elect to apply the new rules before then. 8 A. PARTNERSHIPS SUBJECT TO THE NEW RULES Under current law, partnerships with ten or fewer partners, each of whom is an individual (other than a nonresident alien), a corporation, or an estate of a deceased partner, are excepted from the TEFRA audit procedures. 9 The new partnership audit procedures provide a more generous exception that is broader in terms of both number and type of partners. In particular, partnerships with 100 or fewer eligible partners during a tax year can elect out of the new rules with respect to that tax year. 10 The partnership must make the election annually as part of a timely filed tax return. 11 If a partnership elects out of the new procedures and the IRS subsequently makes an audit adjustment, the IRS must issue a separate audit report to each partner and each partner can then act independently to challenge its own audit report under the deficiency procedures that otherwise apply to individuals. 12 For purposes of the exception, eligible partners include individuals, corporations, foreign entities that would be treated as corporations if such entities were domestic, S corporations, and estates of deceased partners. 13 Unlike a prior proposal, real estate investment trusts and regulated investment companies are not specifically excluded as eligible partners. 14 However, as under the TEFRA rules, a partnership cannot elect out of the new audit procedures if any partner is a limited liability company or limited partnership. In the case of an S-corporation partner, the S corporation s shareholders are each counted as partners in determining whether the partnership has 100 or fewer partners. 15 The Budget Act gives the IRS authority 7 8 9 10 11 12 13 14 15 Bipartisan Budget Act of 2015, Pub. L. No. 114-74, 1101(a), (c), 129 Stat. 584, 625. The Budget Act also repealed the partnership audit procedures that apply to electing large partnerships. Id. at 1101(b). Under those procedures, partnerships with more than 100 partners can elect to flow audit adjustments up to the partnership s partners when the adjustment occurs, rather than to the partners during the year to which the adjustment relates. See I.R.C. 6240-6255 (repealed for tax years beginning on or after January 1, 2018). Bipartisan Budget Act of 2015, Pub. L. No. 114-74, 1101(g), 129 Stat. 584, 638. I.R.C. 6231(a)(1)(B) (TEFRA). I.R.C. 6221(b)(1) (Budget Act). I.R.C. 6221(b)(1)(D) (Budget Act). See, e.g., I.R.C. 6213. I.R.C. 6221(b)(1)(C) (Budget Act). See Partnership Audit Simplification Act of 2015, H.R. 2821, 114th Cong. 2(c) (2015) (proposed I.R.C. 6221(b)(3)). I.R.C. 6221(b)(2)(A) (Budget Act). -3-
to prescribe similar rules for partners that are not specifically identified as eligible partners, such as limited liability companies and limited partnerships. 16 B. PARTNERSHIP AUDIT ADJUSTMENTS Consistent with the TEFRA audit procedures, the new partnership audit procedures require the IRS to conduct a single partnership-level examination. 17 If the IRS makes an adjustment at the partnership level, the default rule in the new procedures provides that the IRS will assess and collect any resulting tax, penalties, and interest at the partnership level. 18 This is a significant departure from the existing TEFRA audit procedures, under which tax is assessed and collected from the partners. 1. Default Procedure: Assessment and Collection at the Partnership Level Under the default rule in the new partnership audit procedures, the IRS will assess and collect tax, penalties, and interest attributable to partnership audit adjustments at the partnership level. 19 Unlike a prior proposal, partners are not subject to joint and several liability for partnership-level assessments. 20 The new partnership audit procedures, however, do not directly address whether or how audit-year partners will be allowed to increase the basis in their partnership interests to reflect the additional income in respect of which the partnership s payments to the IRS are made. The IRS will determine the tax attributable to a partnership-level adjustment by netting all audit adjustments and multiplying that net amount by the highest tax rate in effect for either individuals or corporations for the reviewed year. 21 Partnerships can demonstrate to the IRS that the tax due should be lower because of partner-specific information for the year under audit. 22 For example, a partnership can provide information as to the tax rates applicable to specific partners (such as individuals, corporations, and tax-exempt organizations) and the specific income to which the IRS adjustment gives rise (such as ordinary income, qualified dividends, or capital gains). 23 A partnership can also reduce the imputed underpayment by showing that one or more partners filed an amended tax return reflecting all partnership-level audit adjustments properly allocable to that partner and paid any resulting tax that is 16 17 18 19 20 21 22 23 I.R.C. 6221(b)(2)(C) (Budget Act). I.R.C. 6221(a) (Budget Act). Id. I.R.C. 6221(a) (Budget Act). See Partnership Audit Simplification Act of 2015, H.R. 2821, 114th Cong. 2(c) (2015) (proposed I.R.C. 6241(d)(1)). I.R.C. 6225(b)(1)(A) (Budget Act). I.R.C. 6225(c)(1), (7) (Budget Act). I.R.C. 6225(c)(1), (3), (4) (Budget Act). -4-
due. 24 The new audit procedures give the IRS authority to prescribe guidance on other information that a partnership can provide to the IRS to reduce the imputed underpayment. 25 While allowing the partnership to present partner-level information to reduce the partnership-level tax is helpful in theory, it may be difficult to implement in practice. For example, in a tiered partnership structure, the lowest-tier partnership may not know the identity of the highest-tier partners. Similarly, a partner may not want to reveal its particular tax circumstances to the partnership or the other partners. Moreover, if a partner has special attributes that a partnership relies on to reduce the partnership-level tax, it is unclear how that partner will reap the full benefit of that reduction. A partnership agreement could provide for a special allocation to a partner whose attributes reduce the partnership-level tax attributable to an audit adjustment. However, it is unclear how that would work in a situation where the relevant partner has left the partnership by the time the partnership pays tax attributable to an audit adjustment. 2. Alternative Procedure: Assessment and Collection at the Partner Level To avoid liability at the partnership level, a partnership can elect an alternative procedure under which the partnership issues adjusted Schedules K-1 to the partners who were partners during the tax year to which the adjustment relates. 26 The partners must take the adjustment into account on their own tax returns for the year in which the partners receive the adjusted Schedules K-1. 27 The partnership must make the election and issue the adjusted Schedules K-1 within 45 days after the IRS issues a notice of final partnership adjustment. 28 Under this alternative procedure, the partners rather than the partnership will bear the tax liability attributable to any partnership-level audit adjustments. In this regard, the Budget Act provides that a partner s tax attributes shall be appropriately adjusted to reflect the partner s share of the partnershiplevel adjustment. 29 Although that provision does not specifically refer to tax basis (and is presumably not limited thereto), the provision seems to provide that a partner can increase its basis in a partnership interest to reflect the additional income allocated to the partner. The new audit procedures, however, provide no guidance on a situation where a partner sells its interest after the audit year but before the 24 25 26 27 28 29 I.R.C. 6225(c)(2). I.R.C. 6225(c)(5) (Budget Act). Senator Orrin Hatch has already received comments suggesting that the new partnership audit procedures should identify partner-level passive activity losses as information that a partnership can provide to the IRS to reduce the imputed underpayment at the partnership level. See 161 CONG. REC. S7637 (daily ed. Oct. 29, 2015) (statement of Sen. Orrin Hatch). I.R.C. 6226(a) (Budget Act). I.R.C. 6226(b) (Budget Act). Because the partner must account for the partner s share of the partnership-level adjustment in the year the partner receives the adjusted Schedule K-1, the statute of limitations for assessing tax against the partner for prior years does not seem relevant. I.R.C. 6226(a) (Budget Act). I.R.C. 6226(b)(3) (Budget Act). -5-
partner pays additional tax attributable to the audit year. In that case, the partner may be required to file an amended tax return for the sale year to reflect an increased basis, assuming the relevant statute of limitations is still open. The alternative procedure under the new partnership audit procedures is similar to the existing TEFRA audit procedures in that partnership-level audit adjustments flow through to the partners who were partners during the tax year to which the adjustment relates. In that sense, the alternative procedure creates an exception to the otherwise applicable rule under which assessment and collection occur at the partnership level. Nevertheless, the key distinction between the existing TEFRA rules and the new alternative procedure is that the latter requires the partnership rather than the IRS to flow audit adjustments through to the partners. As discussed above, that process can be complicated and labor intensive. Requiring partnerships rather than the IRS to undertake the necessary analysis is intended to alleviate a major source of the difficulty the IRS faces in auditing large partnerships under the TEFRA audit rules. The extent to which partnerships will take advantage of this alternative procedure remains unclear. The decision to pursue this alternative procedure may depend on the number of adjusted Schedules K-1 the partnership would have to issue, the complexity of preparing those Schedules K-1, the extent to which there has been turnover among the partners, and the magnitude of the tax, penalties, and interest the partnership would otherwise have to bear. Another relevant consideration is that if a partnership elects to pursue the alternative procedure, thereby shifting any liability to the partners during the year under audit, underpayment interest will accrue at a rate that is two percentage points higher than the otherwise applicable underpayment rate. 30 3. Treatment When Partnership Ceases to Exist Under the new partnership audit procedures, if a partnership ceases to exist before the IRS makes a partnership adjustment, the former partners will take the adjustment into account under regulations to be prescribed by the Secretary. 31 From the statutory language, it is unclear whether former partners means the partners during the year to which the adjustment relates or the partners during the year the partnership ceased to exist. Additionally, while it seems this provision would apply in a situation where a partnership sells its assets and then liquidates, it is unclear whether the provision would apply where a partnership becomes a disregarded entity, elects to be taxed as a corporation, or undergoes a technical termination. 32 Future regulations may clarify these points. 30 31 32 I.R.C. 6226(c)(2)(C) (Budget Act); I.R.C. 6621(a)(2), (c). I.R.C. 6241(7) (Budget Act). See I.R.C. 708(b)(1). -6-
C. OTHER PROCEDURAL MATTERS The new partnership audit rules require a partnership to designate a person with a substantial presence in the United States as the partnership representative who has the sole authority to act on behalf of the partnership under the partnership audit procedures. 33 Unlike a tax matters partner under the TEFRA audit procedures, the partnership representative does not have to be a partner. 34 If the partnership does not designate a partnership representative, the IRS has authority to do so. 35 Additionally, the new rules make it more difficult for a partner to participate in the audit process. For example, under the TEFRA rules a notice partner can enter into a settlement agreement with the IRS even if other partners do not. 36 In contrast, under the new audit rules it seems that a partner has no independent ability to settle with the IRS. Similarly, under the TEFRA rules a partner can file a petition in the U.S. Tax Court if the partnership s tax matters partner does not. 37 In contrast, the new rules provide that only the partnership can petition the U.S. Tax Court to challenge an IRS adjustment at the partnership level. 38 However, as under the TEFRA rules, the new partnership audit procedures continue to allow a partner to file a tax return that is inconsistent with the partnership s tax return if the partner properly notifies the IRS. 39 D. IMPLICATIONS AND CONSEQUENCES The new audit procedures will make it easier for the IRS to audit partnerships and collect tax, penalties, and interest attributable to resulting adjustments. For that reason, the Budget Act will likely lead to an increase in both the number of partnership audits and the amount the IRS ultimately collects from those audits. 40 From a transactional perspective, existing partnership agreements may need to be reviewed and possibly revised to account for the new partnership audit procedures. Under the existing TEFRA rules, new partners generally have limited risk with respect to tax exposures in prior partnership tax years. This is because any adjustments attributable to prior partnership tax years flow to the partners in those years. But under the new partnership audit rules, a new partner could end up indirectly bearing a share of such 33 34 35 36 37 38 39 40 I.R.C. 6223(a) (Budget Act). Id. Id. I.R.C. 6224(c) (TEFRA). I.R.C. 6226(b) (TEFRA). I.R.C. 6234(a) (Budget Act). I.R.C. 6222(c) (Budget Act). See, e.g., Laura Davison, Big Deductions, Big Audits? Maybe for Small Partnerships, 209 DTR G-2 (Oct. 28, 2015) ( The rate at which partnerships are audited is expected to increase under the new regime.... ); Aaron E. Lorenzo, More Partnerships Face Audits Under Budget Deal, 208 DTR G-2 (Oct. 27, 2015). -7-
historical tax liabilities if the partnership chooses to pay those liabilities instead of pursuing the alternative procedure discussed above. For this reason, partnerships should consider revising existing partnership agreements to make clear whether the partnership intends to (1) follow the default rule and bear tax liabilities attributable to partnership-level audit adjustments, (2) follow the alternative procedure and pass those tax liabilities to the partners during the year to which the liabilities relate, or (3) evaluate IRS audit adjustments on a case-by-case basis. This may be particularly relevant for partnerships that experience high partner turnover. New partners will likely prefer that a partnership follow the alternative procedure to ensure that partners in earlier tax years bear any tax liabilities attributable to those earlier tax years. However, as discussed above, the potential complexities of the alternative procedure as well as the large corporate underpayment rate that applies under the alternative procedure may deter other long-standing partners from agreeing to that approach. If a partnership agreement does not commit to pursing the alternative procedure, new partners should consider asking for representations, warranties, and indemnities regarding pre-closing tax liabilities. As enacted, the new audit procedures give rise to many unanswered questions. However, citing the delayed effective date of the new procedures, Senator Orrin Hatch, Chairman of the U.S. Senate Committee on Finance, has stated: In the coming weeks and months, the Finance Committee will treat the TEFRA partnership reforms as a work in process. As planned, we intend to hear comments and will be prepared to address issues raised by taxpayers, especially those issues that may not have been anticipated. 41 * * * Copyright Sullivan & Cromwell LLP 2015 41 See 161 CONG. REC. S7637 (daily ed. Oct. 29, 2015) (statement of Sen. Orrin Hatch). -8-
ABOUT SULLIVAN & CROMWELL LLP Sullivan & Cromwell LLP is a global law firm that advises on major domestic and cross-border M&A, finance, corporate and real estate transactions, significant litigation and corporate investigations, and complex restructuring, regulatory, tax and estate planning matters. Founded in 1879, Sullivan & Cromwell LLP has more than 800 lawyers on four continents, with four offices in the United States, including its headquarters in New York, three offices in Europe, two in Australia and three in Asia. CONTACTING SULLIVAN & CROMWELL LLP This publication is provided by Sullivan & Cromwell LLP as a service to clients and colleagues. The information contained in this publication should not be construed as legal advice. Questions regarding the matters discussed in this publication may be directed to any of our lawyers listed below, or to any other Sullivan & Cromwell LLP lawyer with whom you have consulted in the past on similar matters. If you have not received this publication directly from us, you may obtain a copy of any past or future related publications from Stefanie S. Trilling (+1-212-558-4752; trillings@sullcrom.com) in our New York office. CONTACTS New York Andrew S. Mason +1-212-558-3759 masona@sullcrom.com David C. Spitzer +1-212-558-4376 spitzerd@sullcrom.com James R. Gadwood +1-212-558-7346 gadwoodj@sullcrom.com Katherine H. Zhang +1-212-558-4854 zhangk@sullcrom.com Washington, D.C. Donald L. Korb +1-202-956-7675 korbd@sullcrom.com SC1:3978351v10-9-