United States

Proposed partnership audit regulations released by the IRS

TAX ALERT  | 

After an initial delay, the IRS has formally released proposed regulations governing the new centralized partnership audit regime. This new regime will replace the existing so-called TEFRA partnership audit rules for taxable years beginning after 2017. Under the new rules, a single representative of an audited partnership will have the power to bind all of the partnership's direct and indirect partners to the results of an audit. This includes, at one end of the spectrum, any concessions to proposed IRS adjustments, and at the other end of the spectrum, any tax litigation conducted by the partnership representative to challenge proposed IRS adjustments.

These proposed regulations are largely similar to the proposed guidance released and subsequently withdrawn by the IRS in January. They are lengthy and detailed, but mostly relate to technical issues that will only be of concern for partnerships that are audited under the new rules, which will not likely occur before 2020. Accordingly, this alert does not discuss the proposed regulations in detail.

Notably, now with only seven months before the new rules apply, the proposed regulations continue to ‘reserve’ on the most important issue to many partnerships, whether tiered partnerships may push-out their audit adjustments, if any arise under audit, to the ultimate indirect partners in the year under review. Those are the parties that would have enjoyed any related underpayment of partner taxes and should therefore ostensibly be the parties required to compute and restore those underpayments to the IRS. Alternatively, if there was no partner-level underpayment, say, because the ultimate partner was not subject to tax in that year, those are the parties most able to demonstrate that fact to the IRS, by filing an appropriate statement on their next tax return. In this manner, through push-out, current partners in the year the audit occurs avoid having to bear the financial cost of an entity-level tax on the amount of income understated at the partnership level in a prior year, when they may not even have been partners.

The issue of whether push-out applies to tiered partnerships, and a number of related issues, may be resolved if a pending proposal in Congress to enact technical corrections is enacted, or if the IRS and Treasury conclude that they can achieve similar results through regulations, which many believe to be the case under the broad language of the underlying statute. The IRS will be holding a hearing on the proposed regulations on Sept. 18, 2017, and the push-out issue is likely to be a major topic of discussion.

Some have apparently already concluded that there is not enough time to get the regulations working properly, or to enact the technical corrections proposal. In a June 13 letter to the IRS, the American Institute of CPA’s requested the enactment of legislation to delay the effective date of implementation to Jan. 1, 2019, in order to allow the appropriate guidance and procedures to be established. Others have concluded that a mere delay of the effective date will not address the concerns of prospective investors in partnerships, who may be concerned that, without the push-out method, they risk being required to bear the cost of paying for the underpayments of prior year partners. Unless a partner knows that he can and will exit the partnership before the start of 2019 if he does not like the way the rules ultimately come out, a one-year delay will not provide much benefit.

Even with these uncertainties, the most prudent working assumption appears to be that the statute will take effect as planned in 2018 and that push-out will be available for tiered partnerships, either under regulations or upon enactment of the technical corrections bill. Even under those assumptions, however, partnerships should now be reviewing their organizational documents and managerial arrangements to address the business conflicts created by this new regime.

In particular, partnerships need to decide whether they will push-out assuming that the option is available, and if they do, who will make decisions for the partnership regarding whether to agree to particular proposed IRS adjustments, particularly if they only or mainly affect prior partners no longer holding interests in the entity. In an extreme case, the current manager and current partners may be indifferent to the audit outcome, since they were not managers or members in the year under audit and can push-out the costs of making adjustments to the appropriate former partners. In such a case, former partners may need to ensure that their interests are protected as the current partnership representative negotiates with the IRS on an issue the current partners do not care about, because it only affects former partners. At the same time, if the partnership representative is going to argue on behalf of former partners, current partners may need to be sure that the former partners are paying the costs of any disputes with the IRS, since they may be the only ones affected by the outcome, under the push-out approach.  

In addition, some smaller partnerships or limited liability companies (LLCs) with under 100 direct partners and no partnerships as partners may wish to ensure that they remain, on account of their size, exempt from the new rules. If that is the case, it may be appropriate for these smaller partnerships and LLCs to consider transfer restrictions or similar limitations.

For these and related reasons, partners and partnership managers may wish to consult their tax or business advisors prior to, and in anticipation of, these new rules to determine if a potential redraft of their partnership agreement is necessary in order to deal with the issues arising from this new law.

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