The BBA Partnership Audit and Assessment Rules take effect January 1, 2018 – Has your Partnership or Operating Agreement been updated?
Effective January 1, 2018, the Bipartisan Budget Act of 2015 (the “BBA”) will govern IRS audits of partnerships, joint ventures and multimember LLC’s filing as partnerships. The new BBA rules (replacing the TEFRA rules) significantly streamlines the IRS’s partnership audit and adjustment process. The new rules allow the IRS to assess and collect under paid taxes, penalties and interest at the partnership level as opposed to the partner level, making it much easier for the IRS to audit partnerships and assess and collect taxes. It is anticipated that the BBA rules will result in a dramatic increase in the amount of partnership audits and raise an estimated $9.3 billion in revenue over the next 10 years.
The BBA’s single set of rules for both partners and the partnership provides a fundamental change in the way the IRS will examine and collect taxes, as the BBA will essentially pass the burden from the IRS to the partnership to collect the tax from its partners. How the partnership will collect the tax, and from whom they can collect, must be addressed by updating your existing partnership or operating agreement. Some of the more significant BBA rules that require additional review and discussion are addressed below.
PARTNERSHIP LEVEL vs. PARTNER LEVEL
Under the old TEFRA rules, IRS audits performed at the partnership level resulted in any adjustments being assessed against each partner, each of whom were entitled to participate during the audit process. These rules were an administrative nightmare for the IRS, which is presumably why the IRS historically audited less than one (1%) percent of partnerships. Under the BBA, IRS audits for a particular year (the “reviewed year”) are still at the partnership level. However, the BBA authorizes the IRS to assess any “imputed underpayment” at the partnership level (generally at the highest individual rate of tax rather than at the separate partners’ individual tax rates), and then to collect any under paid taxes, penalties and interest from the partnership in the year the audit is completed (the “adjustment year”). Consequently, if there are different partners in the adjustment year than in the review year, partners can be responsible to pay for someone else’s income tax liability. This radical outcome should be discussed and addressed through updated indemnification provisions in your partnership or operating agreement.
AUDIT NOTICE AND CONTROL
Alarmingly, the IRS is not required to provide notice to individual partners of a partnership audit, the individual partners have no statutory right to participate in the IRS audit or any resulting appeal, or raise partner level defenses. There will no longer be a “tax matters partner.” Instead, the partnership must designate a “partnership representative” (“PR”) for each tax year, who is the only person permitted to deal with the IRS. The PR will have the sole authority to act on behalf of and bind the partnership and its partners. Accordingly, your partnership or operating agreement must be amended if you want to impose additional obligations upon the PR to apprise the partners of an IRS audit and provide them with additional protections.
The BBA applies to all partnerships (broadly defined to include almost any unincorporated joint business operation, which includes joint ventures and limited liability companies that have elected to be treated as a partnership), except for certain qualifying partnerships that affirmatively elect out of the BBA rules. Generally, a qualifying partnership must meet each of the following three (3) requirements in order to elect out: (1) have 100 or fewer qualifying partners; (2) have only eligible partners which include: individuals, the estate of a deceased partner, “S” Corps, “C” Corps or foreign entities treated as a “C” Corp; and (3) attach an annual election statement to a timely filed tax return. Ineligible partners include the following types of partners: partnerships (tiered structures), trusts (including grantor trusts) and disregarded entities (including single member LLC entities).
For partnerships that are subject to the BBA and cannot elect out, there are two (2) options to mitigate the damage at the partnership level. The partnership can make a “push-out” of the additional tax liability from the partnership to the partners who were present during the reviewed year; or alternatively, the partnership can seek a modification of the imputed amount by following specific rules published in the regulations. In order to take advantage of either option, your partnership or operating agreement should be amended to include a mechanism for making such election and obtaining partner consent.
The BBA rules may lead to complications and increased costs unless a thorough examination of your ownership structure is conducted, thoughtful planning is implemented, and your partnership or operating agreement is appropriately amended. If you are a partnership, joint venture or multimember LLC, you should promptly contact your counsel at Semanoff Ormsby Greenberg & Torchia, LLC to discuss what changes are required to your partnership or operating agreement.
Jeffrey G. DiAmico