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On November 2, 2015, the President signed the Bipartisan Budget Act of 2015 (the Act), which includes revenue provisions that install a new audit system for most partnerships, effective for tax years beginning after December 31, 2017. The Bipartisan Budget Act replaces the existing TEFRA and ELP procedures for all partnerships with 100 or more partners and any other partnership with a flow-through partner (including a disregarded entity).

The provisions relating to partnership audits contained in the Bipartisan Budget Act signed by the President are the same as the provisions included in the House bill, H.R. 1314 (See Tax Alert 2015-2046). A partnership not required to be under the new system (e.g., those with fewer than 100 partners) must elect out of the new system annually to be excluded. The provisions were enacted in a hurried fashion and may requirement amendment. Chairman Hatch has stated that Congress intends to hear comments and will be prepared to address issues raised by taxpayers, especially on those issues that may not have been anticipated.

Background

There are currently three regimes under which partnerships are audited. Partnerships with 10 or fewer partners are examined at the partner level. The partnership return is audited, but adjustments are proposed for each partner separately, requiring separate audits to be opened by the IRS for each partner. For most large partnerships with more than 10 partners, the IRS conducts a single administrative proceeding under the rules of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), with issues determined at the partnership level rather than at the partner level. The resulting adjustments are then determined for each partner and applied to the year under audit. The elective large partnership (ELP) procedures established streamlined audit and adjustment procedures, as well as a simplified reporting system, for those large partnerships that specifically elected to be treated as an ELP. For ELPs, the IRS generally makes adjustments at the partnership level that then flow through to the current-year partners who hold their partnership interest during the year in which the adjustment takes effect. The partnership can be liable for the adjustments in certain situations. Very few partnerships have elected ELP status since the ELP procedures were enacted in 1997.

New partnership audit procedures

The Act repeals the TEFRA and ELP rules and creates a single set of rules for auditing partnerships and their partners at the partnership level. The IRS will examine the partnership's items of income, gain, loss, deduction, and credit and partners' distributive shares for a particular year of the partnership (the reviewed year). Any adjustments will be taken into account by the partnership in the year that the audit or any judicial review is completed (the adjustment year). Partners would not be subject to joint and several liability for any liability determined at the partnership level. If partnerships establish to the satisfaction of the IRS that the adjustment would be lower if it were based on partner-level information rather than the imputed amount determined by applying the highest rate, then the amount of the an imputed underpayment may be revised.

Partnerships have several options under the new procedures. Partnerships with 100 or fewer qualifying partners may elect out of the new regime and elect to be audited under the traditional rules applicable to small partnerships whereby the IRS audits the tax return of each partner.

Partnerships that are subject to the new partnership audit provisions are examined at the partnership level and must pay an imputed tax on adjustments that result in an imputed underpayment. Adjustments that do not result in an imputed underpayment must be taken into account at the partner level.

The statute allows partnerships subject to the new partnership audit provisions to elect into an alternative payment process rather than have the partnership pay an imputed underpayment. As an alternative to paying an imputed underpayment at the partnership level, a partnership may elect to utilize the alternative method and furnish to each partner of the partnership, for the reviewed year, a statement showing the partner's share of any adjustment, in which case those partners would take the adjustment into account on their individual returns in the year they receive such statement.

A partnership may also initiate a correction and file an "administrative adjustment request" relating to any partnership tax year to adjust the reporting of a previously reported item. Under the administrative adjustment procedures, the adjustment is determined and taken into account for the tax year in which the administrative adjustment request is made. Prior year tax returns are not amended. Adjustments resulting in imputed underpayments may be taken into account by either the partnership or the partners. If the adjustment would not result in an imputed underpayment, the partnership may not take the adjustment into account at the partnership level. Such adjustments must be taken into account under procedures similar to the alternative method applicable to adjustments made as a result of an IRS audit and must be made at the partner level.

Default rule

Under the default rule, a partnership would be responsible to pay any imputed underpayment relating to the reviewed year, which is generally paid in the adjustment year. If the audit adjustment does not result in an imputed underpayment, it may not be taken into account at the partnership level and must be taken into account by each reviewed year partner in a process similar to the alternative process described below. The partnership would also have the ability to establish to the satisfaction of the IRS any amounts that would have been allocated to tax indifferent partners and adjust its payment liability accordingly. Under the default rule, the adjustment would be subject to the tax rates in effect during the reviewed year. This default rule allows the partnership to settle any adjustment with the IRS with minimal administrative effect to its partners.

Under the default rule, in the case of any adjustments that reallocate distributive share items from one partner to another, the new provisions essentially force the filing of amended returns by all affected partners. Under the default provision, an allocation adjustment will result in an imputed underpayment at the partnership level since the statute ignores favorable adjustments and only takes into account unfavorable adjustments for purposes of determining an imputed underpayment. This result does not occur if all partners affected by the adjustment file amended returns. For example, if an adjustment would reallocate income from one partner to another, the IRS could assess an imputed tax on an underpayment against the partnership equal to the net income/gain allocable to the partner with increased distributive share of income, while not taking into account and netting any adjustment attributable to the partner with a decreased distributive share of income. To avoid an imputed underpayment at the partnership level, all affected partners must file amended returns. Only by having all amended partner-level returns filed would the partner entitled to a refund be able to obtain the refund.

Alternative method

If utilized, the alternative method would allow a partnership to furnish statements to its "reviewed year" partners, who would then report the income in the year the statement is furnished. It is unclear how the tiering process would work under the alternative method. The Treasury and the IRS will need to issue guidance to set forth the process in those situations.

In determining the amount of any tax owed or refund due under the alternative method, a partner must apply the tax rate of the reviewed year, and take into account any adjustments for changes to tax attributes resulting from the audit adjustments, as if the income had been properly accounted for in the reviewed year. Tax attributes utilized in the tax years that fall between the reviewed year and the tax year in which the adjustment is being reported must also be taken into account in determining any additional tax owed or refund due. The statute requires tax attributes to be "appropriately adjusted." There may be a significant difference in overall tax liability, as well as increased administrative burden when a partnership elects to utilize the alternative method instead of the default rule. It is unclear what specifically constitutes a tax attribute and how extensively the IRS will require a taxpayer to analyze the effect of adjustments related to tax attributes.

The election to use the alternative method must be made no later than 45 days after the final notice of adjustment has been issued. In addition, the partnership must furnish the required statements to each reviewed-year partner. The IRS and Treasury are directed to issue guidance on the method by which a partnership may make the election and the time and manner in which the partnership must furnish statements to reviewed-year partners.

Partnership designated representative

A key change included in the new partnership audit rules relates to the replacement of the role of the current "tax matters partner." Under the statute, the partnership is provided authority to designate a partner or any other person with a substantial presence in the United States as the partnership representative with the IRS. This "partnership representative" replaces the current "tax matters partner" rules that apply under the current TEFRA regime. The key difference is that the partnership representative would have the sole authority to bind the partnership and all partners in the partnership on partnership adjustments. If the partnership does not have such a designation in effect, the IRS may select the person to be the partnership representative.

Implications

The changes to the partnership audit provisions contained in the Act will significantly alter the audit and income tax liability rules governing partners and partnerships, and, as such, will have significant implications for partners of partnerships. Under today's system, partners in any given year are liable for any adjustments to reported taxable income; under the revised system, tax liability may be borne by partners in a later year. There will likely be unforeseen complications for partnerships and partners as the changes to the partnership audit provisions contained in the Act are implemented, such as changes in partners over tax years and partnerships going out of existence. The IRS will also need to issue guidance to address many of the provisions in the Act, including, among others, the mechanics of partners taking into account adjustments to partnership allocations, imputed underpayments, assessments against partners, and the collection aspects for assessments at the partnership level. All partnership agreements, whether new or old, should address the effect of the Act.

Application to asset managers

The provisions of the Act will have significant implications to hedge funds given their investor make-up and partnership tax status. Although many hedge funds may have less than 100 partners, most hedge funds have at least one partner that is also a partnership (i.e., typical master-feeder structure), rendering most, if not all, ineligible to elect out of the new regime. Consequently, hedge funds will either be subject to the provisions of the default rule, or have the option to elect to be subject to the alternative method for imputed underpayments.

Under the alternative method, in a typical master-feeder structure, the master fund under audit would generally only have two partners, and therefore the adjusted K-1s would be provided to the feeders, not the partners of the feeders. Whether the US feeder would then be responsible to pay the tax, or issue adjusted K-1s to its investors will have to be determined through additional guidance to be issued by the IRS and Treasury. There may be instances when a fund would find it beneficial to utilize the default rule to minimize the administrative and overall tax burden.

As an example, a hedge fund with overstated capital losses in the review year whose partners were able to use the capital loss to offset short-term capital gains may be required to determine whether those losses would have offset long-term capital gains had the loss been properly accounted for in a subsequent year. Fund managers may need to consider whether the default rule would produce appropriate results for the adjustment-year partners given historical allocation methodologies and given the minimal administrative burden that investors would be facing.

There is a considerable amount of guidance the IRS and Treasury will need to provide taxpayers on the application of these new provisions. Undoubtedly though, we expect these revised procedures to make audits of hedge funds more streamlined for the IRS, potentially causing an increase in the number of audits that the IRS can perform in a given year. It would be prudent for fund managers to revisit their record-keeping and documentation processes to ensure all tax positions have adequate support in the case of an audit. An assessment should also be made regarding financial statement reporting implications of the new rules and the elections thereunder. Fund managers should be aware of the options under these new rules and understand the effect of the alternatives based on each partnership's particular facts and circumstances. Future structuring considerations should be reviewed now to maximize the number of partnerships that would be eligible to elect out of the default rule.

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