Virtually all private equity ("PE") funds rely heavily on entities taxed as partnerships in structuring both the fund-level investment and the acquisition and ownership of portfolio companies. Whether legally formed as a limited partnership or limited liability company, partnership tax characteristics, such as single-level taxation, income allocation flexibility and the almighty carried interest, make the partnership tax form vital to meeting a fund’s economic objectives. Thus, dramatic changes in the manner in which partnerships resolve their tax disputes with the Internal Revenue Service (“IRS”) warrant the private equity community’s attention.
On Nov. 2, 2015, President Obama signed into law the Bipartisan Budget Act of 2015 (the “Act”). The Act dramatically changes the way the IRS will conduct partnership audits going forward and, in turn, likely will have far reaching implications on how partnerships, including funds, conduct operations in the future.
Congress’s intent in passing the Act was to increase revenue by streamlining the current audit process and making it easier for the IRS to perform audits and collect on resulting liability. Historically, the partnership audit rate and resulting revenue has been significantly lower than the corporate rate and revenue, primarily due to the fact that the partnership audit rules are more complex and the resulting liability is collected at the partner level, rather than from the partnership. For example, in 2014, the IRS audited only 0.8% of partnerships having at least 100 partners and $100 million in assets compared with a 27.1% audit rate for similarly positioned corporations1.
The new audit rules apply to all partnerships, including limited liability companies taxed as partnerships, with more than 100 partners and to partnerships with fewer than 100 partners if any of the partners is itself a partnership or trust. For purposes of calculating the number of partners, an S-corporation is disregarded and each of its shareholders is considered to be a partner. All other partnerships may elect, on an annual basis, to opt out of the regime, in which case the current rules will continue to apply. The new rules will affect returns filed with respect to taxable years beginning on or after Jan. 1, 2018; however, a partnership may elect to have them apply sooner.
Current Partnership Audit Regimes
Under the current rules, one of three audit regimes applies to resolving disputes with the IRS depending on the size of the partnership and the composition of its members. Partnerships with more than 10 members are subject to the rules introduced by the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”). Under the TEFRA rules, the IRS makes partnership-level adjustments to certain items (“partnership items”) and passes the adjustments on to the partners by recalculating each partner’s individual share of the resulting liability. Partners are required to take into account their portion of the total liability by submitting amended returns for the year under audit. TEFRA requires a partnership to appoint a tax matters partner (“TMP”) to communicate with the IRS during an audit. The TMP does not have the authority to bind the other partners in any negotiations with the IRS. All partners are entitled to receive audit-related information and notices and have the right to participate in the audit if they so choose.
Small partnerships with 10 or fewer partners are subject to the same audit regime that applies to individuals, unless the partnership elects to be subject to the TEFRA rules. Finally, large partnerships with at least 100 partners are subject to a simplified TEFRA regime, which limits the participation rights of the partners in the audit. However, unlike smaller partnerships, the adjustments generally do not affect prior year returns. If the IRS determines there was a deficiency in a prior year, partners take into account the partnership-level adjustment in the year in which the audit is conducted, rather than amending their individual returns for the reviewed year.
New Streamlined Audit Procedure
Under the new partnership audit rules, the TMP is replaced with a “partnership representative” who is afforded greater authority than under the old regime. The partnership representative has the sole authority to act on behalf of the partnership and to bind the partnership in decisions related to the audit. The remaining partners have no notice rights relating to the audit or any resulting adjustments.
The Act also makes significant changes to the audit procedure itself, including which party is liable for an adjustment. The new default rule is that where the IRS determines there has been a deficiency, the adjustment liability is imposed on the partnership, rather than being passed on to the partners. Further, a deficiency is assessed at the highest individual or corporate tax rate in effect for the year under audit (the “reviewed year”), unless the partners are able to demonstrate that the adjustment would be lower if it were based on certain partner-level information for that year (i.e., some partners were subject to lower tax rates).
As an alternative to the default rule, the partnership may elect to pass the deficiency on to the partners who were members of the partnership in the reviewed year by issuing adjusted Schedules K-1. The partners are required to take the adjustments into account in the year in which they receive the adjusted Schedules K-1 (the “adjustment year”), rather than amending their returns for the reviewed year. The partnership must make the election to pass the deficiency on to the partners within 45 days after the IRS issues a notice of final adjustment. The IRS has yet to release guidance on how the election will be made and the timeframe for issuing adjusted Schedules K-1.
The Act also allows partnerships to self-report adjustments, in which case a partnership may take the adjustment into account in the adjustment year or issue adjusted Schedules K-1 to the reviewed-year partners. It should be noted that the Act, which provides a statutory framework for the new rules, does not include much of the technical guidance that almost certainly will be necessary to implement the new audit regime. Such rules likely will be provided through a combination of Treasury Regulations and direct IRS guidance over the next couple of years leading up the Jan. 1, 2018, effective date.
Although these rules have not yet taken effect, they should be taken into account when drafting new operating agreements or engaging in acquisitive transactions involving partnerships. Operating agreements should include procedures that address the option to elect to pass any adjustment on to the reviewed-year partners. Additionally, partners should clearly define their respective rights to notice and participation during an audit and carefully select the partnership representative that will have the authority to bind the partnership.
These changes will also have a significant impact on partnership merger transactions. The new rules contemplate that where an entity, resulting from a merger or acquisition, is considered to be a continuation of an existing partnership (rather than a new entity), that entity will inherit any pre-closing liability. This means that future partners may end up having to bear the burden of a pre-closing adjustment, even if they were not involved in the partnership in the reviewed year. Parties to partnership M&A transactions must take into account these rules when negotiating who has control over audits for pre-closing years, which party will bear the cost of pre-closing adjustments and what elections the partnership will be permitted to make.
From a fund-management perspective, PE funds should take notice that simplifying the audit procedures for partnerships likely will have the effect of increasing the number of audits undertaken by the IRS — from the disproportionately low levels noted above. Given the amount of capital deployed through PE funds, it only stands to reason that they will receive their share of this unwanted attention. Accordingly, PE funds should familiarize themselves with these rules and stay on top of the regulations that should be forthcoming and will flesh out the statutory framework.
1U.S. Gov. Accountability Office, GAO-14-732, Large Partnerships: With Growing Number of Partnerships, IRS Needs to Improve Audit Efficiency (2014).