Dramatic Changes to Partnership Audit Rules Will Impact Private Investment Funds and other Partnerships
The Bipartisan Budget Act of 2015, signed into law in November 2015, has significantly changed the rules governing the audits of entities treated as partnerships for U.S. federal income tax purposes. The new partnership audit rules are certain to significantly impact any such entity, including hedge funds, private equity funds and other private investment vehicles.
The new rules apply only to tax audits of taxable years beginning on or after January 1, 2018, unless a partnership elects to apply them to an earlier taxable year. While it is unlikely that partnerships will make this election, as they must await additional detailed IRS guidance with respect to the application and operation of the new rules, it is not too early for taxpayers to consider the potential impact of these new rules on both new and existing partnerships and partnership agreements. Offering materials and partnership or operating agreements for new private investment funds should be prepared taking into consideration the new partnership audit rules. In addition, existing offering materials and partnership agreements or operating agreements should be updated and amended to reflect the impact of the new rules.
The new partnership audit rules replace the current regime for auditing partnerships under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) and the rarely-used special electing large partnership rules enacted in 1997. Under the current audit procedures, the Internal Revenue Service (IRS) audits partnerships at the partnership level but is required to separately assess and collect tax from each partner. In a significant change from the current law, the new audit rules now provide that the IRS will impose an entity-level tax in the year in which the audit is completed directly on the partnership that is subject to an audit adjustment (plus penalties and interest thereon). The partnership’s tax liability initially is calculated by multiplying all net adjustments by the highest marginal federal tax rate (currently 39.6%). As such, the persons who are partners during the year in which the audit is finalized will bear the economic burden of the tax even though the underpayment relates to a prior year.
However, as described in more detail below, the new audit rules provide partnerships with an elective mechanism under which the tax liability attributable to any partnership-level audit adjustments may be shifted away from the partnership (and thus the partners in the tax year the audit is finalized) back to those persons who were the partners during the tax year subject to the audit. This election should be particularly useful to investment vehicles, such as hedge funds, where there are significant year-to-year changes in the identity of partners, and most hedge funds are therefore expected to make the election.
Partnerships Subject to the New Rules
All partnerships are subject to the new audit rules, unless they are permitted to elect out. A partnership can elect to opt-out of the new rules if it has 100 or fewer partners consisting exclusively of individuals, C corporations, S corporations, estates of deceased partners, and foreign entities that would be treated as C corporations if such entities were domestic. In the case of an S corporation partner, all of the S corporation’s shareholders must be identified to the IRS and each of the S corporation’s shareholders is counted in determining whether the partnership has 100 or fewer partners;
The election is made annually. If a partnership elects out and the IRS makes an audit adjustment, the IRS must issue a separate audit report to each partner and each partner can then independently challenge its own audit report under the deficiency procedures that apply to individuals. Any partnership with even a single partner that is a partnership or trust cannot opt out. Consequently, investment partnerships with any partnerships or trusts as partners, including investment partnerships with tax-exempt entities that would be treated as trusts for U.S. federal tax purposes or that have partnerships as partners (such as master funds), will not be able to elect out. Accordingly, virtually all private investment funds will be subject to the new audit rules.
Default Procedure: Assessment and Collection at the Partnership Level
As previously noted, under the default rule in the new partnership audit procedures, any adjustment, assessment and collection of tax, interest and penalties owing by the partners as a result of a partnership audit will be made at the partnership level and taken into account by the partnership in the year that the audit is finalized. The partnership will be required to pay the imputed underpayment of tax (plus interest and penalties), which is determined by netting all adjustments to items of income, gain, loss and deduction and multiplying the result by the highest individual or corporate rate in effect for the year which is subject to the audit. A partnership’s imputed underpayment can be reduced to the extent partners voluntarily file amended returns and pay any tax due for the audited year, or if the partnership demonstrates that the income would be allocable to partners that are either not subject to tax (i.e., tax-exempt or foreign persons) or taxed at preferential rates (i.e., capital gain or qualified dividend income allocable to an individual or income allocable to a corporation). The new audit rules also direct the Treasury to establish procedures under which the imputed underpayment amount may be modified “consistent with the requirements” of these rules and based on “other factors as the Secretary determines are necessary or appropriate to carry out the purpose of [the new audit rules].” It is unclear to what extents these procedures will further reduce a partnership’s imputed underpayment amount.
Despite the uncertainty, it is clear that all partnerships, including private investment funds, will need to maintain very detailed information regarding the identity and tax status of its partners and the direct and indirect owners of such partners.
Because under the default rule the partnership will be directly liable in the year in which the audit is completed for taxes assessed with respect to the year under audit, the economic burden of the tax will be borne by the persons who are the partners during the year the audit is finalized. This could impose all or a portion of the tax burden on partners who were not partners, or had a lower percentage interest, in the partnership in the year subject to the audit. Accordingly, any partnership that has partners whose interests may change over time, including investment vehicles, should include in its partnership agreement indemnity obligations under which each partner and former partner agrees to indemnify the partnership for their respective shares of any tax liabilities incurred by the partnership as a result of the new audit rules.
As discussed above, investment partnerships that have significant changes in the identity of partners from year to year are likely to elect the alternative procedure available under the new rules under which the persons who were partners during the year to which the adjustment relates, rather than the partnership and its partners in the year the audit is finalized, will bear the tax liability attributable to any partnership level audit adjustments. This alternative procedure is described immediately below.
Election to Shift Liabilities Back to Partners
As an alternative to the general rule that an imputed underpayment is assessed and collected at the partnership level, a partnership that receives notice of a final partnership adjustment may elect to shift the burden of the adjustment to the persons who were the partners during the year subject to the audit. The partnership must make the election within 45 days after the IRS issues the notice of final partnership adjustment and furnish (at such time yet to be prescribed by the IRS) to each person who was a partner during the year to which the adjustment relates a statement (essentially a revised Schedule K-1) showing each such partner’s share of any adjustment[s] arising from the audit. The partners (or former partners) will then be required to compute the impact of the adjustment on their tax liabilities for the year under audit (and the years after the year under audit and before the year the audit is finalized) and report any resulting increased taxes on, and pay such taxes with, their respective tax returns for the year the audit is finalized. In addition to the tax, the partners will be assessed penalties and interest running from the due date of the return for the earlier year(s) that generated the tax liability, but with interest payable at a rate that is two percentage points higher than the normal underpayment rate.
While it is unclear, the partnership might be liable for any taxes not paid by the individual partners receiving the adjusted Schedule K-1s. Accordingly, partnerships should consider including in their partnership agreements distribution holdbacks or indemnity obligations from any partners that fail to pay the taxes with respect to their respective adjusted Schedule K-1s.
The decision by a partnership to elect this alternative procedure will depend on various considerations, including the extent to which there is turnover among the partners, the complexity of preparing the adjusted Schedule K-1s, the two percentage points higher underpayment interest rate under the alternative procedure, and the magnitude of the tax, interest and penalties that the partnership would otherwise have to bear. However, as previously noted, investment vehicles that have high turnover among their partners are likely to elect this alternative procedure.
The new audit rules eliminate the concept of a “tax matters partner” and now require the partnership to appoint a “partnership representative” who will have the sole authority to act for and bind the partnership (and its partners) in all IRS disputes. Under the new audit rules, partners retain no rights in administrative proceedings and cannot contest IRS determinations separately form the partnership. However, partners do have the right to file a tax return that is inconsistent with the partnership’s tax return (unless and until the partnership representative reaches an agreement with the IRS to finalize an audit) with notification to the IRS. Unlike the “tax matters partner”, the partnership representative is not required to be a partner is the partnership. The partnership representative can be any person that has a “substantial presence in the United States”, but until guidance is issued it is unclear what level of presence is required. This is a useful change for investment partnerships, as a non-partner investment manager or advisor can now serve in this capacity on behalf of the partnership. If the partnership does not designate a partnership representative, the IRS is entitled to appoint one for the partnership.
The new partnership audit rules represent a dramatic change from existing law and will have a significant impact on new and existing partnerships, including investment partnerships. As enacted, the new audit procedures give rise to many unanswered questions. Many of the details of these rules are reserved for future guidance from the IRS. In addition, technical corrections to, or changes in, the rules may be enacted. We will be watching for and examining these developments very carefully, and will keep you informed.
Both existing and new partnerships should consider taking steps now to prepare for potential audits under the new rules. More specifically:
- Offering documents for existing investment funds should add disclosure regarding the new audit rules and offering documents for new funds should be drafted taking the new rules into consideration.
- Existing partnership agreements and LLC operating agreements, including fund partnership and operating agreements, should be reviewed and revised to reflect the new rules.
- New partnership and operating agreements, including new fund partnership and operating agreements, should be drafted taking the new rules into account.
- Partnerships, including investment funds, should obtain and update more detailed information, including tax status, not only of its partners, but also of the direct and indirect owners of the partners.
- Purchasers of partnership interests should be made aware of the potential tax burden from audits of years prior to the acquisition and obtain appropriate indemnities regarding pre-closing tax liabilities.
- Partnerships electing to issue adjusted Schedule K-1s to the persons who were partners in the year under audit should consider distribution holdbacks and/or obtaining indemnities from partners with respect to their failure to pay any taxes relating to their respective adjusted schedule K-1s.
- Partnerships should consider including covenants in their partnership agreements to provide notices and information to partners relating to tax audits and other proceedings and requiring the partnership representative to obtain the consent of some percentage of the partners prior to binding the partnership.
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