On November 2, 2015, new partnership audit rules were enacted as part of The Bipartisan Budget Act of 2015. The new audit rules could have a significant impact on partnerships generally and on investment partnerships in particular. The new rules were enacted because the IRS and Congress felt that the current audit rules, referred to as TEFRA, were difficult to apply and to collect taxes under. The audit rate for large partnerships is currently only about 1% as opposed to about 30% for large corporations. The new rules are scored to raise about $10 billion over a 10-year period.
The new audit rules are effective for taxable years beginning after December 31, 2017, so they are effective for 2018 and later years for calendar year taxpayers.
Although the new audit rules are not effective until taxable years beginning after December 31, 2017, existing partnership operating agreements, offering memorandum, subscription agreements, and side letters will generally need to be revised before then to include certain provisions reflecting the new audit rules and new fund documents will need to include such provisions as well.
We expect that most funds, particularly hedge funds, will elect to have partnership adjustments pass through to partners rather than having partnerships be liable for tax at the entity level.
CURRENT RULES – TEFRA. The current audit rules were enacted under TEFRA (Tax Equity and Fiscal Responsibility Act of 1982) and special electing large partnership rules were enacted in 1997. Very few partnerships have elected to be subject to the large partnership rules. TEFRA applies to partnerships with more than 10 partners. Under the current audit rules, the IRS must assess and collect tax from each ultimate partner. The IRS has found it very difficult administratively to audit large partnerships and effectively have the partners pay tax on audit adjustments. This has resulted in fewer audits of large partnerships. As a result, there have been several proposals over the last year to change the rules for auditing partnerships.
WHAT THE NEW RULES PROVIDE. The new rules repeal both the TEFRA audit rules and the electing large partnership audit rules. The new rules are similar to the electing large partnership audit rules. The new rules are designed so that the IRS only has to deal with the partnership and not each partner.
The new rules generally provide that the partnership will be liable for taxes assessed as a result of audit changes. For example, if a partnership’s 2018 federal tax return is audited in 2020 and it is agreed that there should be an adjustment with respect to the 2018 tax return, the partnership would be liable for the tax on its 2020 tax return, even if the partners in the partnership have changed. The rules provide that only partnerships can challenge the IRS adjustments. The rules are intended to shift the administrative burden of audits to partnerships.
The new rules are much better than the recent proposals. For example, the new rules do not include joint and several liability for partners, and provide an option to elect out of partnership liability and pass through audit adjustments.
Significant Guidance; Technical Corrections. The IRS will need to issue lengthy guidance on how the new rules will apply. The new rules raise many issues and it will take many months if not years to address many of these issues. Technical corrections may need to be enacted as well.
Effective Date. As stated above, the new rules are not effective until taxable years beginning after December 31, 2017. The rules allow a partnership to elect into the new rules earlier than their effective date, but partnerships would likely not make this election.
“Small Partnership Election”. Partnerships with 100 or fewer qualified partners may elect out of the new rules (small refers to the number of partners and not to assets or income). This election is an annual election. Such electing partnerships would be subject to pre-TEFRA rules (i.e., each partner would need to be issued notices of deficiencies and audited). Partnerships with nonqualified partners (that is, partners that are not individuals, C corporations, S corporations or estates) are not eligible to elect out of the new audit rules. S corporations are looked through for determining the number of partners. Partnerships with partners that are partnerships (i.e., tiered partnerships) would not be allowed to elect out under the small partnership election unless this is permitted under IRS guidance. Master funds would not be able to elect out under the small partnership election because they are tiered partnerships. Many standalone domestic funds would also not be able to elect out.
Partnership Tax Adjustments. The partnership is generally liable for tax, interest and penalties on adjustments at the partnership level for the year the audit (or judicial review) is resolved (referred to as the “adjustment year”), not in the year being audited (referred to as the “reviewed year”). The tax is calculated by multiplying the net adjustment by the highest applicable federal rate (currently 39.6%). The tax is included on the partnership’s tax return for the adjustment year. This can be lowered if the partnership demonstrates that the income is allocable to foreign persons and tax-exempt persons, if the income is attributable to lower taxed income (i.e., long-term capital gains or qualified dividend income), or if the partners file amended tax returns for the reviewed year reflecting the pass through of the adjusted items (and also file amended tax returns for later years reflecting adjustments to tax attributes for years after the reviewed year).
The positive or negative income adjustment (referred to as the “partnership adjustment”) is calculated by netting all items of adjustment. However, if an adjustment is merely a reallocation from one partner to another, the adjustment only takes into account the positive adjustment.
Election to Have Partners Include Adjustments and be Liable for Tax (“Pass-Through Election”). The partnership may elect to have the partners include the adjustments and taxes on their tax returns for the adjustment year. The tax is calculated as if all the adjustments (rather than just one netted amount) were included on their tax returns for the reviewed year (and adjusting any later year taxes as a result of changed tax attributes that were carried over). The partners rather than the partnership would then be liable for the tax. Interest charged on any underpayment is at a rate 2% higher than the normally applicable federal interest rate that would be charged on additional taxes. Tiered partnerships would presumably be entitled to make a similar election.
This election to pass through must be made within 45 days of the audit being completed. The burden of passing through adjustments to partners would be on the partnership as opposed to the IRS under current rules.
“Partnership Representative” Replaces “Tax Matters Partner”. The new rules replace the concept of a “tax matters partner” with the concept of a “partnership representative”. A partnership representative has much more power than a tax matters partner. Instead of a “Tax Matters Partner” (“TMP”), a “Partnership Representative” (“PR”) will need to be designated in the partnership agreement. Unlike a TMP, the partnership representative is not required to be a partner in the partnership. The PR is required to have a substantial US presence. A TMP has a duty to keep partners informed and partners may participate in administrative proceedings. Under the new rules, partners will not be required to be notified regarding audit developments, will not be able to participate in audits under the new rules, and will not be able to contest the results.
Many Issues and Uncertainties. The new audit rules are very complicated and leave many issues unanswered. What about the net investment income tax (also known as the Medicare Contribution Tax) or self-employment tax? The applicable tax rate does not includes the NII tax so that these taxes may be able to be avoided. The net adjustment simply nets all partnership adjustments which may be advantageous. Can the net adjustment be a way for investor partnerships to get the benefit of deductions for which partners might otherwise not have benefited?Can capital losses in excess of $3,000 be used to offset ordinary income? What about basis adjustments? Whose partnership basis is adjusted for changes taxed at the partnership level?
Future Guidance; What Can Be Expected. It is likely that significant guidance will need to be issued before the new audit rules become effective. It is possible that the rules will be changed and/or that technical corrections will be enacted to make changes to the new rules. Lawyers and other tax advisors along with the IRS will need to spend a significant amount of time on the issues generated by the new rules. As discussed below, a number of changes will need to be made to fund documents and those changes will evolve over time as guidance is issued and experience is gained. It remains to be seen whether the new rules can accomplish their intended goals.
IMPACT ON HEDGE FUNDS AND PRIVATE EQUITY FUNDS.
1. More audits of hedge funds and private equity funds can be expected since this is one of the objectives of the new audit rules.
2. Offering Memorandums will need to be updated to disclose the new rules and their impact, including that the partnership, and effectively current partners, could be liable for taxes that relate to prior years.
3. Fund Operating Agreements will need to be amended. Instead of a “tax matters partner”, a “partnership representative” will need to be designated in the partnership agreement. Operating Agreements will need to provide the partnership representative with powers to handle audits and make elections. Operating Agreements should also address allocations among partners and require partners to provide certain information.
4. Will the Pass-Through Election swallow the general rule. That is, will most partnerships elect to pass through adjustments rather than have the partnerships be liable for taxes. We would anticipate that most funds, particularly hedge funds because their partners may change over time, will elect out of partnership liability, and that the Pass-Through Election will swallow the general rule.
5. Investors may request in side letters that the partnership will make the Small Partnership Election (if the partnership is considered to have 100 or fewer partners) or the Pass-Through Election. It may be that this is accepted subject to a de minimis exception or specific dollar threshold below which a partnership is not required to make these elections.
6. Funds that make investments in other funds or in other partnerships may make similar requests in side letters for fund investments.
7. Will the new rules have an effect on investing in MLPs.
8. The new audit rules may also affect the purchasing and selling of interests in partnerships, including purchasing and selling interests in fund managers.
9. Will the new rules put more or less pressure on partnership tax issues. This may depend on the particular tax issue in question.
10. To the extent a partnership could be liable for tax, the partnership may need to consider whether this should be addressed in their FIN 48 analysis. Will auditors require a Small Partnership Election or a Pass-Through Election so that they do not require or need to examine whether a tax reserve is required.
11. Partnership Agreements may need to include indemnification provisions regarding taxes paid and tax sharing provisions setting forth how taxes or adjustments are shared or allocated among the partners.
12. Will partnerships try to stay under the 100-partner limitation and only have qualified partners so that the partnerships can make the Small Partnership Election.
13. Could the new rules have an impact on whether a master feeder structure or mini-master feeder structure is used since the master or mini-master may be more likely to be audited.
14. Will more management companies be structured as S corporations so that they do not prevent a partnership from being able to elect out.
15. Could the new rules have an impact on tax return positions taken by funds due to increased audit risk and potential partnership level tax liabilities.
16. Will state and local tax authorities follow the IRS’s lead and enact similar rules.