On November 2, 2015, Congress enacted the Bipartisan Budget Act of 2015 (BBA), which contained sweeping changes to the Internal Revenue Code’s (IRC) partnership audit, litigation, assessment, and collection procedures. The BBA repealed the partnership audit and litigation rules enacted as part of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), which had governed the practice of tax advisors and the IRS for more than three decades. The BBA also replaced TEFRA’s partnership “tax matters partner” with a new “partnership representative,” in whom it vested vast powers, including the sole authority to act on behalf of a partnership and to bind all partners on partnership matters covered by the BBA. In light of these expanded powers, partners must carefully consider the person that they select to be the partnership representative. The failure to do so could be financially calamitous.
The BBA Audit Rules
The BBA enacted default audit rules that apply to all partnership income tax returns filed by entities taxed as a partnership beginning January 1, 2018. The defining feature of the default rules is to establish a centralized partnership audit regime that, in general, provides for the assessment and collection of tax, including penalties and interest, exclusively at the partnership level. The scope of the adjustments determined at the partnership level is broad; it includes any items of income, gain, loss, deduction, or credit relating to a partnership’s tax return [IRC section 6221(a)]. As such, the BBA audit rules did away with such terms as “partnership items,” “affected items,” and “computational adjustments,” which caused litigation under the TEFRA regime.
The BBA audit rules further provide that any underpayment in tax, penalties, and interest determined will be assessed and collected against the partnership in the year that the audit or litigation is concluded (absent what is defined as a “push-out” election), rather than the actual tax year of the partnership that is under examination. This could result in current partners shouldering the financial burden for tax liabilities attributable to tax years for which they were not even partners in the partnership. The tax due will be assessed at the highest federal marginal rate for individuals and corporations for the year under audit [IRC section 6225(b)(1)].
A partnership can ameliorate the harshness of taxation at the highest marginal rate under IRC section 6225 in three ways. First, the amount of tax assessed against the partnership can be reduced if one or more partners file an amended return for the tax year under audit, taking into account the allocable share of the partnership adjustments, and pay the tax due [IRC section 6225(c)(2)]. Second, the proposed under-payment will be reduced if the partnership can demonstrate to the IRS that one or more partners are tax exempt [IRC section 6225(c)(3)]. Third, the underpayment will also be decreased if the partnership can prove that a portion of the underpayment is subject to a lower rate of tax, such as a capital gain or qualified dividend income [IRC section 6225(c)(4)].
Alternatives to the Default Rules
Partnerships can avoid the default rules of the centralized audit regime in two ways: by “electing out” of the BBA procedures, or by making a push-out election. Both options have their pros and cons.
The electing-out alternative is available to partnerships that issue no more than 100 Schedule K-1s and whose partners are only individuals, C corporations, foreign entities that would be treated as C corporations if they were domestic, S corporations, or estates of deceased partners [IRC section 6221(b)(1)(C)]. A partnership choosing to elect out must do so annually on a timely filed partnership return (including extensions) for the taxable year to which the election relates [IRC section 6221(b)(1)(D)(i)].
The most significant consequence of electing out is that the audit will be conducted and assessments will be made at the individual partner level, governed by each partner’s statute of limitations, for the year under examination. The audit procedures, therefore, will be similar to the partner-by-partner tax deficiency examinations that existed before TEFRA. Some partnerships may find it strategically advantageous to elect out and require the IRS to conduct individual partner audits.
The second alternative is the push-out election. This election permits a partnership to flow through partnership audit adjustments to those persons who were partners in the tax year under audit [IRC sections 6226(a)-(b)]. A push-out election must be made no later than 45 days after a Notice of Final Partnership Adjustment (FPA), which concludes a partnership audit, is mailed to the partnership [IRC section 6226(a)(1)].
Under the push-out election, the partnership is required to provide a written statement to the IRS and each partner for the year under audit setting forth each partner’s allocable share of the partnership adjustments of income, gain, loss, deduction or credit, and any penalties. The partners must report the additional tax and penalties in the year that they receive notice of the adjustments from the partnership. There is a cost to the push-out election that must be considered: the underpayment rate of interest charged to each of the partners is two percentage points greater than the normal rate of interest that would apply under the default rules [IRC section 6226(c)(2)(C)].
The most significant consequence of electing out is that the audit will be conducted and assessments will be made at the individual partner level.
The Partnership Representative
The liaison between a partnership and the IRS under the TEFRA audit procedures was the tax matters partner, who had the authority to bind the partnership in audit and litigation matters. Individual partners also possessed meaningful notification and participation rights, both in the context of the audit and in any subsequent litigation, that have been completely eliminated under the BBA audit rules. The BBA replaces the tax matters partner with the partnership representative, to whom it gave broad and exclusive powers that may ease the administrative burdens of the IRS but will be an unwelcome surprise to many unwary partners and tax advisors.
Unlike the tax matters partner, who was required to be a partner in the partnership, a partnership may designate any individual or entity, even a nonpartner, as its partnership representative so long as the partnership representative has a “substantial presence in the United States” and the “capacity to act” [proposed Treasury Regulations sections 301.6223-1(b)(2)-(b)(4)]. If an entity is selected as the partnership representative, the partnership must also identify and appoint a “designated individual” to act on behalf of the entity.
A partnership representative has a substantial presence in the United States if the partnership representative is available to meet with the IRS in person in the United States at a reasonable time and place, as determined by the IRS; has a U.S. street address and telephone number; and has a U.S. tax identification number. A partnership representative has the capacity to act unless the partnership representative is disqualified by such events as death, incapacity, incarceration, a court order enjoining the partnership representative from acting on behalf of the partnership, or the liquidation or dissolution under state law of an entity operating as a partnership representative [proposed Treasury Regulations 301.6223-1(b)(2)-(b)(4)].
The designation of a partnership representative must be done annually on the partnership tax return and is effective on the date that the return is filed. The designation must include information to demonstrate that the partnership representative has a substantial presence in the United States and that there are no impediments to the partnership representative’s capacity to act.
The Authority of the Partnership Representative
The BBA rules grant the partnership representative vast powers, including the sole authority to act on behalf of the partnership in—
- all matters involving the examination of the partnership’s return;
- the conduct of administrative practice before the IRS, including protests to the Appeals Office and requests for Private Letter Rulings; and
- litigation in court of disputed tax adjustments.
The extent of the power vested in the partnership rep-resentative necessitates that partnerships and their partners make a business-minded decision when selecting the partnership representative.
This exclusive authority means that a member of a partnership has no right to be notified of the commencement of an audit, to be updated on its progress, or to participate in the audit itself or in litigation disputing audit adjustments, unless the partner happens to be the partnership representative.
The power of the partnership representative also includes the exclusive authority to bind all partners with respect to extensions of the statutes of limitations, settlements with the IRS, the decision to challenge or not to challenge adjustments in an FPA, which partnership-level defenses to assert, the making of partnership elections, and the payment of partnership tax liabilities. The proposed Treasury Regulations provide that neither state law nor the partnership agreement can curtail the broad authority granted to the partnership representative under the BBA rules [proposed Treasury Regulations section 301.6223-2(c)(1)].
The extent of the power vested in the partnership representative necessitates that partnerships and their partners make a business-minded decision when selecting the partnership representative. Among the factors to be considered are whether the partnership representative should be a partner or a nonpartner; whether the partnership representative should have IRS audit and tax litigation experience; whether the partnership representative is likely to act in a fiduciary capacity to the benefit of all partners, or serve only the interests of a few; the time commitment involved in acting as a partnership representative; and the length of the term that the partnership representative will serve.
Although the proposed Treasury Regulations provide that the statutory authority granted to the partnership rep-resentative under the BBA audit rules cannot be abrogated by the partnership agreement or state law, partnerships and their partners are advised to address the scope of the partnership representative’s powers, and the partnership representative’s responsibilities to the partnership, through an amendment to an existing partnership agreement or the drafting of a new agreement. The partnership agreement should discuss how the partnership representative is selected and removed; impose an obligation on the partnership representative to provide timely notice to partners of all significant communications with the IRS during an audit and any ensuing tax litigation; consider restricting the partnership representative’s power to make elections, extend the statute of limitations, settle disputes, litigate tax issues, and decide how tax assessments will be paid; and include dispute resolution procedures for disagreements that are likely to arise between the partnership representative and one or more of the partners.
Choose the Right Person
The centralized audit regime of the BBA rules was designed to ease the administrative burden of the IRS in conducting partnership audits, as well as to advance the IRS’s goal of auditing more partnership income tax returns and collecting more tax. The substantial and unilateral powers vested in the partnership representative under the BBA rules are a central component of the IRS’s new strategy for partnership audits. Partnerships and their partners, in consultation with their tax advisors, must exercise sound business judgment in selecting a partnership representative, as well as in establishing procedures to ensure that the partnership representative acts in the best interests of the partnership.