All private investment funds should be aware of the recent changes in the law regarding federal income tax audits of partnerships.
These changes are expected to significantly increase the number of partnership audits conducted by the Internal Revenue Service - particularly audits of large partnerships such as funds. The most significant aspect of the legislation is that it makes partnership audits easier and less costly, giving the IRS the opportunity to conduct a larger number of partnership audits with the same resources.
Prior to the effective date of this legislation, when the IRS audits a partnership, it generally is required to allocate the resulting adjustments to partnership income to the partners in the year subject to audit and assess any additional tax due on each of the partners.
The new legislation shifts much of the burden from the IRS to the partnership by requiring the partnership to either pay the additional tax resulting from the audit directly, or allocate the adjustments among its partners in the year subject to audit.
The federal government has estimated that due to the complex and time consuming nature of partnership audits relative to corporate audits, less than one percent of large partnerships were audited by the IRS as compared to more than twenty five percent of large corporations. Effectively, large partnerships, which have increased in number with the rise in popularity of private equity funds, hedge funds and master limited partnerships, were practically exempt from federal income tax audits because of the tremendous IRS resources required to effectively report adjustments to, and assess and collect tax from, each partner in the partnership.
The new partnership audit rules generally will apply to partnership tax years beginning after December 31, 2017. Due to practitioners’ significant criticism of the rules and identification of areas where the new rules fail to provide sufficient guidance and clarity, Congress may consider amendments to the rules in 2017, which may include a deferral of the effective date. The new audit rules will be applicable to all entities treated as partnerships for federal income tax purposes, including limited liability companies that have not elected to be treated as corporations.
Overview of the Partnership Audit Rules
Under the current law, the IRS generally has the burden of determining any errors in the partnership’s calculation of its income or loss, then allocating such adjustments to the partners and collecting any additional tax due from each partner in the year subject to audit. Under the new audit rules, adjustments to partnership items are determined at the partnership level, and the partnership generally is responsible for any additional tax resulting from such adjustment in the year the audit concludes and the assessment is made.
As a result, following such new procedures can create an inequity between the partners that received the economic benefit or detriment from the partnership items for the year subject to audit, and the partners of the partnership in the adjustment year that bear the economic cost of the additional taxes imposed on the partnership. That is, if the IRS audits a partnership’s tax returns for the 2018 calendar year and completes the audit in 2020 resulting in an assessment against the partnership, the partners in 2020 -- who may be different from the partners in 2018 -- bear the cost of the understatement of income of the partnership in 2018 based upon their ownership interests in 2020.
The new partnership audit rules, however, also allow partnerships to elect to pass any audit adjustments through to their partners in the year under review, referred to as the “alternative method.” Under the alternative method, the partnership issues adjusted information returns to the partners in the year under review, and those partners are required to reflect the adjustment through a simplified amended return process.
Under the new audit rules, partnerships are required to designate a partner (or other) as the partnership’s representative which shall have the sole authority to act on behalf of the partnership for purposes of the new audit rules. Such representative’s powers to unilaterally settle audits and make elections under the new audit rules are very broad unless limited by contract.
Planning for the New Partnership Audit Rules in Transactions
Private equity funds acquiring an interest in a partnership must be aware of the risk that such partnership could be assessed and pay taxes resulting from an audit of a year prior to the fund’s ownership. Accordingly, a purchaser of a partnership interest should either negotiate the right to request that the partnership elect the alternative method so that the audit adjustments flow through to the partners in the year under audit.
Alternatively, if the fund cannot bind the partnership, the fund may seek indemnification from the selling partner in the event the fund bears the cost of audit adjustments relating to a year before it became a partner in the partnership.
In addition, private equity funds must be aware that they remain at risk of incurring additional tax costs following the disposition of an interest in a partnership if such partnership elects the alternative method and audit adjustments arising in a subsequent year are allocated to the partners in the year that was the subject of the audit.
This could be a significant issue if the adjustments are large and the fund that owned the interest in the partnership interest sold the majority of its investments or liquidated following the disposition of such interest in the partnership.
Further, because the partnership’s representative has broad power to make elections and negotiate settlements unless limited by contract, private equity funds should actively participate in the amendment of current partnership agreements, or the drafting of new partnership agreements, to require the vote or consent of other partners prior to such representative making elections or settling claims under the new audit rules.