Temporary regulations (see T.D. 9780) were released by the IRS on August 2, 2016, which provide guidance regarding the making of an election-out from new IRS partnership audit rules. The rules were first brought into law under the Bipartisan Budget Act of 2015 (BBA), and were later amended by the Protecting Americans from Tax Hikes Act of 2015 (PATH). The temporary regulations address the form, timing and manner in which the election is to be made.
The new rules are applicable to partnership tax returns filed for tax years beginning after December 31, 2017. However, partnerships may elect out from the new rules with respect to any returns filed for tax years beginning after November 2, 2015, the effective date of the BBA. These years are “eligible taxable years” with respect to the new IRS partnership audit procedures.
Until the enactment of the BBA, partnership audits were conducted under the “TEFRA” rules. TEFRA (Tax Equity and Fiscal Responsibility Act of 1982) is the acronym used for a set of consolidated examination, processing, and judicial procedures which determine the tax treatment of partnership items at the partnership level for partnerships, and limited liability companies (LLCs) that file as partnerships. The BBA repealed TEFRA (and related audit rules for electing large partnerships), replacing them with audit and adjustment procedures that apply by default to all partnerships. Under these new BBA rules, adjustments to partnership items are determined by default at the partnership level, and any additional tax is assessed and collected by default at the partnership level, including any penalties and interest owing, unless the partnership elects to pass on the tax adjustment to its partners, in which case each partner becomes responsible for tax, penalties and interest. In effect, this is an “election-out” by the partnership from the default treatment under the new IRS partnership audit rules enacted by the BBA.
Making the Election
Partnerships may make the election-out after notification by the IRS that the partnership has been selected for audit. In that event, the partnership making the election-out must file a statement with the words “Election under Section 1101(g)(4)” stated at the top of the page, and address the statement to the IRS agent identified in the IRS Notice advising the partnership of its selection for examination. The statement must be in writing and dated and signed by the Tax Matters Partner, by a specially designated “partnership representative,” or by an individual who has authority to sign the partnership return for the tax year in question. A partnership may elect-out in some years and not in other years, because the election-out is made for one year at a time, but once the election-out is made for a year, it can be revoked only with IRS consent.
A partnership may elect-out for a year if:
- The partnership issues no more than 100 Schedules K-1 to its partners
- Each partner is an individual, an estate of a deceased partner, a Subchapter S corporation, a Subchapter C corporation, or a foreign entity that would be treated as a Subchapter C corporation if it were a domestic entity
- The election-out is filed with a timely filed partnership income tax return that includes the names and identification numbers of the partners, and
- The partnership notifies each partner of the election-out.
Very notably, in the event that a partnership has a partner that is another partnership or a trust, including a grantor trust, the election-out may not be made. Similarly, a partnership with partner that is a tax-exempt organization must first determine whether the partner is treated as a Subchapter C corporation or a trust for tax purposes, before attempting to elect- out.
Additional guidance is provided under the temporary regulations for a partnership that wants to file a request for administrative adjustment (AAR) under the BBA rules but has not received a Notice of selection for examination; for a partnership that has already filed an administrative adjustment request (AAR) under the existing TEFRA provisions for any partnership tax year occurring within the early adoption period; and for a partnership that is not subject to TEFRA procedures but has filed an amended return for any partnership tax year occurring within the early adoption period.
Consequences if the Election-Out cannot be, or is not, made
In the event that the partnership has not elected-out for the year under examination, and an IRS adjustment is made, the underpayment payable by the partnership is computed by multiplying the “highest rate of tax in effect for the reviewed year under Section 1 or 11” (meaning, the higher of the highest individual or corporate rate) by the net adjustment, after considering all items of income, gain, loss, or deduction for the audited year. Notably, the partnership-level underpayment does not include any other taxes, such as self- employment tax or net investment income tax, that might be payable by one or more of the partners individually under an elect-out scenario. However, note that provision is made under Code Section 6225 (effective after December 31, 2017) for income allocated to Subchapter C Corporations (where the 35% tax rate may apply), or for capital gains or qualified dividend income allocated to an individual, since such income is subject to maximum tax rates well below the normal highest individual income tax rate of 39.6%.
Options to consider
Under the audit rules provided by the BBA and the new temporary regulations, Partnerships’ Tax Matters Partners, Sponsors and Managers need to consider certain actions and choices when crafting or amending a partnership agreement, to take into account the ability to make the election-out described above. These include:
- Should the partnership agreement be amended or drafted to require an election-out to be made, if and when the partnership qualifies for the election-out?
- Should the partnership agreement require the partners of the year under examination to reimburse the partnership for imputed underpayments made by the partnership in the adjustment year?
- Should partners in the reviewed year be liable to the partnership for underpayments paid by the partnership in the adjustment year, if they are not partners in the adjustment year?
- Should the partnership agreement permit or prohibit transfers of partnership interests to persons who would terminate or prohibit the election-out? (This could greatly limit the types of partners that would be eligible to be partners in the partnership).
- Should the partnership agreement state the circumstances under which the partnership will make the election-out to shift the burden for an IRS adjustment from the partnership to the partners?
- Should a purchaser of a partnership interest, or a partner who was not a partner during the reviewed year, be directly or indirectly liable for tax paid by the partnership for that year?
- Who can designate the partnership representative for the purpose of making the election-out? Should the partnership agreement appoint partners to guide the decisions of the partnership representative? Alternatively, should the agreement empower the Tax Matters Partner to determine if the partnership will or will not elect out?
With the demise of the TEFRA rules, a partnership may, under certain conditions, opt out of the new IRS audit rules altogether, or allocate the income attributable to a partnership tax adjustment to persons who were partners for the year to which the adjustment relates. While effective for partnership tax years beginning in 2018, partnerships may choose to adopt the rules for any tax year beginning after November 2, 2015, the date of the BBA’s enactment. Partnerships’ Tax Matters Partners, Sponsors and Managers should come to grips with the new rules, and review existing partnership agreements in light of the new rules. Partners in existing partnerships, or those joining partnerships, need to be aware of the new audit rules, and how a partnership’s ability to elect-out may affect them. FGMK can assist you in reviewing partnership and operating agreements in light of the new audit rules, and assist in assessing the best options for partnerships and partners.
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