The New Partnership Audit Rules: How the Private Equity and Venture Capital Sector Can Prepare (article)
With all of the tax changes taking effect in 2018, the private equity and venture capital sector may have overlooked an important change: the new partnership audit rules. The IRS’s new rules for auditing partnerships, introduced in the Bipartisan Budget Act of 2015 (BBA), took effect for tax years beginning after Dec. 31, 2017.
The centralized partnership audit regime could have a significant effect on private equity and venture capital funds, which are often structured with partnerships. Although there are some exceptions to the rules, the complex partnership structures utilized by many private equity and venture capital firms may prevent them from opting out of the new rules. As a result, investors must be prepared for the rule changes, and may want to take the time to revisit partnership agreements before they find themselves subject to an IRS audit. There are some planning options available to push any adjustments back down to the partnership level, but the plan to use them should be in place before an exam would begin. Additionally, there are proactive steps a partnership can take to minimize conflict around how to allocate assessments among partners.
How the New Rules Differ from Previous Practices
The BBA upended the traditional approach the IRS used to audit partnerships. Previously, the IRS conducted examinations of partnerships with 10 or fewer eligible partners with separate audits of the partnership and each partner. Examinations of partnerships with more than 10 partners and partnerships with any ineligible partner (partnerships, trusts, certain foreign entities, estates, and certain other entities) were conducted under the TEFRA unified audit procedures, where any adjustments were unified and binding on the partners. Partnerships with 100 or more partners could elect to be electing large partnerships (ELP). Any audit adjustments for ELPs were treated on a unified basis and reflected on the partners' current year return. In any of these three ways to audit a partnership, refunds or payments resulting from any examination adjustments generally were paid to or collected at the partner level.
TEFRA procedures and the ELP designation were repealed under the BBA. Under the new rules, the IRS will examine any item or amount relevant to a partnership’s income tax liability during the “reviewed year” and assess any adjustments (imputed underpayments) in the year the review is completed, “the adjustment year.” Imputed underpayments will be paid at the partnership level in the adjustment year.
There is an opt-out election for partnerships with 100 or fewer eligible partners. However, partnership entities themselves cannot be eligible partners within another partnership entity. Thus, typical investment fund entities that have a general partner that is structured as another partnership will not be able to opt out of these new rules.
2018 Developments Affecting the Centralized Partnership Audit Regime
In their initial iteration in the BBA, the new partnership audit rules contained numerous provisions that were unclear. The IRS published proposed regulations to help clarify some of the biggest issues, including the opt out rule, selecting a method of addressing an imputed underpayment, and allocating imputed underpayments among partners when partnership interests changed between the reviewed year and the adjustment year.
In the absence of final guidance on some of the unclear provisions, the American Institute of CPAs (AICPA) had asked Congress to delay the start of the new partnership audit rules by one year. In March, President Trump signed a spending bill, the Consolidated Appropriations Act of 2018 (CAA), that finalized some of the ambiguous provisions in the centralized audit regime. Addressing the new partnership audit rules also affirmed that the new rules were in effect for the 2018 tax year. Below are some of the key clarifications that the CAA addressed.
Initially, it was unclear as to whether the adjustment, which takes the assessment out of the partnership level and back onto the partners in the reviewed year, would only be available for direct partners.
The CAA affirmed that partnerships can implement the push-out adjustment election for all tiers of ownership. Fund arrangements will likely benefit from the CAA clarification, as they typically involve multiple layers of partnerships with frequent changes in interest as investments are bought, sold or traded, making it highly likely that the partners in the adjustment year may be different or hold a different proportion of interest than the partners who were involved in the partnership during the review year.
Partnerships can elect the push-out adjustment by filing a tracking report with information about the push-out adjustment and sending it to all partners, including indirect partners. Partners may also elect the adjustment by paying their share of the tax. Due dates for the filing of the tracking report or the share of the taxes paid is the tax return date (including extensions) of the adjustment year.
The CAA also permits partners to push out favorable audit adjustments (imputed overpayments) to all tiers of ownerships. As originally written, only underpayments were permitted to use the push-out adjustment.
Self-Employment and Net Investment Income Taxes
Some partnerships may choose to follow the new centralized audit regime to reduce the administrative burden of divvying up the imputed underpayment among their partners. Another clarification in the CAA may make following the default rule less appealing, particularly for complex partnership arrangements.
The CAA provides that even if a partnership elects to take the imputed underpayment at the partnership level, the partners would still be liable to pay any self-employment or net investment income taxes that result from the imputed underpayment. Partners who would owe taxes as a result of the imputed underpayment would need the information from the partnership about the amount of taxes they owe and they would also need to file amended returns for the assessment year.
Passive Loss Rules
The CAA confirmed principles in the IRS proposed regulations that favorable and unfavorable adjustments could only be netted if they were of the same character (capital or ordinary). It also provided that taxpayers cannot net items of partnership loss that could be subject to the passive loss rules of Section 469.
If partnerships do not want to use the push-out adjustment election, they will have another option to push imputed underpayments down to the partner level. Using pull-in procedures, some or all of the reviewed year partners will calculate and pay individual taxes by making changes to their tax attributes as a result of the partnership audit adjustments. The pull-in procedures could be used without filing an amended return and without resulting in any corollary effect on the partners’ recalculated returns on other tax years beyond the effects on tax attributes. Further guidance is needed on how partners report and pay the pull-in procedure.
Other 2018 Partnership Audit Rules Updates
The IRS issued final regulations on the role of the partnership representative in 2018 as well. Under the centralized partnership audit regime, only the partnership representative interfaces with the IRS during the audit examination. Designated partnership representatives have the sole authority to act on behalf of the partnership and any action they make is binding for the partnership and its partners.
Final regulations clarify that a disregarded entity can serve as a partnership representative, and a partnership may designate itself as a partnership representative. The final regulations also provide guidance on the timeline for changing a partnership representative and the procedures for a resigning representative.
Action Items for Partnerships
Partnerships may have delayed evaluating the new partnership audit rules in hopes that Congress would delay the effective date. The CAA and final regulations issued by the IRS indicate that the regime is in effect now. To prepare for the rule changes, partnerships should review their options for paying imputed underpayments and amend partnership agreements as needed. The push-out and pull-in procedures require partners to be in agreement that funding tax deficiencies at the partner level is in the best interest of the partnership. Once an IRS exam of a partnership begins, partners will have limited time to evaluate their elections or modification options.
For more information about how the new partnership audit rules could affect your partnership, please contact us.
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