On November 2, 2015, the President signed into law the Bipartisan Budget Act of 2015 (the “Act”). The Act had numerous provisions, none of which relate to tax except almost the very last provision which now provides new rules for auditing partnerships. Under the Act, absent elections discussed below, all adjustments to income and tax liabilities resulting from a partnership audit and the tax assessment (meaning imposition of liability for the adjustments) will be made at the entity level for all partnerships, not just widely held or publicly held partnerships as the case is now. This is a significant departure from prior law and requires practitioners to be aware of the elections that are available and the consequences from failure to elect. The following are the salient points:
- The default rule is that any partnership level adjustment will result in a tax assessed to the partnership by multiplying the adjustment by the highest statutory corporate or individual rate in place during the tax year.
- Certain partnerships may elect out of such treatment but only qualified partnerships by following certain procedures.
- Partnerships eligible to elect out must have fewer than 100 partners, each of which is either an individual, corporation (C-Corp. or S-Corp.), or estate.
- If a partnership has even one partner that is itself a partnership it is ineligible to elect out.
- In counting the 100 partners, each shareholder of an S-Corporation that is a partner counts toward the 100 threshold.
- The election must be made each year on a timely filed return.
- The election must identify each partner (and each shareholder of an S-Corporation) by name and taxpayer identification number (no form provided yet).
- Each partnership must notify its partners of the election.
- The partnership will be assessed a tax based on the adjustment multiplied by the highest statutory tax rate, however, another election will allow liability to be pushed off to the partner.
- An election may be made under Section 6626 to avoid the entity level underpayment by making a separate election to have the adjustment made to the effected partners.
- The election must be made within 45 days of receiving notice of final partnership adjustment.
- The partnership would be required to issue an adjusted Schedule K-1 to every partner in the affected year.
- This election also must be made for each year there is an adjustment. An election is only effective for that particular audit year.
- Effective date – this is another of the “sleeper” provisions in that it applies for tax years beginning after December 31, 2017, meaning the first time you will be making these elections for your small partnerships to opt out of the entity level adjustment and payment is in 2019 when returns are filed for the 2018 taxable year.
Obviously the availability of the election is important and will involve more schedules and more reporting since it must be done each year. Treasury is given authority to promulgate regulations to flesh out the new procedures meaning that whatever Treasury says, you will have to do. As legislative regulations, they would have to be completely arbitrary and against the intent of the statute to be overturned. Secondly, the election for particular audits are separate and are done on an audit by audit basis.
One of the big concerns with these procedures is that if a partnership’s 2018 return is audited and changes are made, this audit is likely to occur and changes made in later years, perhaps 2021 or 2022. An adjustment and assessment could be imposed, for example, in 2021 if the audit is completed then but the tax liability will be economically borne by those who are partners of this partnership in 2021. Anyone who was a partner in 2018 and who has since left the partnership would not be affected by the audit or the payment of the individual tax or the fact that perhaps he got more deductions or losses than he was entitled to absent these elctions. In other words, subsequent partners can be paying for the sins of the prior partners which tends to make them very unhappy.
- This highlights the importance of making the elections and at least being aware of the elections to be made.
- The Act will allow the IRS, in the event of a reallocation of income or loss between partners, to assess additional tax for any partner whose income was increased without being obligated to net the adjustment between partners, again, heightening the importance of the elections to move changes to the partner level.
- Expect to see provisions in partnership agreements and in documents where partnership interests are purchased demanding representations, warranties, and tax indemnities from sellers for adjustments made to years in which they were partners.
Arthur A. DiPadova is a shareholder in the firm. He earned his J.D. at the Rutgers University School of Law, where he graduated with honors. He earned his LL.M. in Taxation at New York University. Mr. DiPadova’s particular areas of expertise include estate, partnership and real estate taxation, corporate taxation and business planning.