In November 2015 Congress passed the Protecting American from Tax Hikes Act of 2015 also known as the 2015 Bipartisan Budget Act (commonly referred to either as PATH 2015 or BBA) repealing the current procedure for partnership audits. Rules and Regulations are forthcoming but it is important to know a few key points, terms and changes.
Effective Date: The new rules go in effect for any post-2017 Partnership Return Audit, so partnerships have time to plan for and amend existing agreements.
Representation of the Partnership in IRS Proceedings: Tax Matters Partner is replaced by a Partnership Representative. The Partnership Representative does not have to be a partner of the Partnership and unlike the Tax Matters Partner, has the power to bind the partnership. This can be curtailed with drafting provisions (i.e. requiring the Partnership Representative to get consent from a majority of the partners prior to entering into any agreements with the IRS).
Timing: During an audit there is a “Review Year”, meaning the tax year under review, and an “Adjustment Year”, the year in which the adjustment is made. These are not the same. This leads to an issue where the partners of the Review Year are not the same as the partners under the Adjustment Year.
Potential Double Taxation: In the case of reallocations from one partner to another, a decrease in income or gain and an increase in deduction, loss or credit is ignored. This creates a problem of double taxation as the income that was misallocated is taxed twice and no corresponding deduction is permitted.
Default Rule: the Partnership (and therefore its current partners) is liable for the underpayment of tax from the Review Year in the Adjustment Year. This situation, if not drafted for, makes transferring, assigning or selling partnership interests difficult as there is unknown liability on the future partners. This problem can be addressed in several ways:
- Indemnity Clause requiring partners from the Review Year to indemnify the Partnership for any liability in the Adjustment Year. This can create new issues such as the new partners not wanting to fight IRS adjustments knowing they will be indemnified by the Partners from the Review Year, or if past partners are bankrupt or deceased the indemnity may not be effective.
- Opting out of the default rule. The Partnership may elect out of the default rule by furnishing a statement of the partner’s share of adjustment to income, gain and loss to each partner and the IRS within 45 days of notice of final partnership adjustment. One of the goals of this legislation was to reduce the burden on the IRS. By putting the responsibility of allocating the adjustment on the Partnership it theoretically accomplishes this. There is another downside to opting out, the interest on the underpayment is increased by 2% points.
- An election to opt out under Section 6221(b) can be filed each year with the Partnership’s tax return provided it meets the following requirements
- 100 or fewer K-1s issued
- Each partner must be an individual, a C corporation, an S corporation or an estate of a deceased partner
- Partnerships must look-through S corporations and disclose the identity of each shareholder (including tax identification numbers)
As you can tell the new sections are complex, and it will take time for rules and regulations to flush out many of the details. However all partnerships should take the time to review their documents and ensure that they are updated with the new terms.
For more information on planning for these changes, please contact Kelly Halpin or Brian Beck.