August 11, 2020

Volume X, Number 224

August 11, 2020

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August 10, 2020

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New Partnership Audit Rules Will Radically Change Partnership Tax Examinations

The rules for auditing partnership income tax returns will change radically beginning in 2018. The most significant change is that tax deficiencies determined in a partnership audit may be collected from the partnership itself, unless the partnership elects to “push out” the deficiency to its partners. The new rules also change the partnership examination process. Among other things, the new rules replace the “tax matters partner” with a “partnership representative,” who will have greater authority to represent the partnership in examinations and to make decisions that will bind the partners.

Partnerships and multiple-member LLCs taxed as partnerships should consider amending their agreements to prepare for the new rules. There is no one-size-fits-all approach that will work for all partnerships, however. Instead, partners should determine what provisions make sense in light of the partnership’s membership, size, activities, and other factors. This article summarizes the new partnership audit rules and identifies some of the key issues that partners and partnerships should consider in drafting or amending their agreements.


Before 1982, any adjustment to an item related to a partner’s interest in a partnership required the Internal Revenue Service (“IRS”) to conduct a separate examination of each partner. These separate examinations sometimes led to inconsistent treatment of different partners, either because the audits themselves produced different results or because the IRS was able to audit some but not all partners. In addition, each partner could challenge the IRS’s determinations in a separate proceeding, leading to further inconsistencies and an inefficient use of taxpayers’ time and resources.

The Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”) addressed many of these issues.  TEFRA created procedures that allowed the IRS to make adjustments to “partnership items” in a single partnership-level proceeding. Once the partnership-level proceeding became final, the IRS made computational adjustments to each partner’s return. Partners were allowed to raise defenses to non-partnership items in separate, partner-level proceedings but generally could not challenge partnership items determined in the partnership-level proceeding.

Since enactment of TEFRA, partnerships have increased in size and complexity. According to a 2013 report by the Government Accountability Office (“GAO”), the number of partnerships with more than 100 partners and $100 million or more in assets more than tripled between 2002 and 2011. The GAO report also noted that nearly two-thirds of large partnerships had more than 1,000 members, and several hundred partnerships had more than 100,000 direct and indirect partners.

These changes made it difficult for the IRS to audit large partnerships. In 2012, the audit rate for large partnerships was just 0.8 percent, compared with 27.1 percent for large corporations. When the IRS completed an audit of a large partnership, the process of passing the adjustments through to partners was extremely time-consuming and, in many cases, affected partners could not be located, were no longer partners in the partnership, or both.

Congress enacted the new partnership audit rules as part of the Bipartisan Budget Act of 2015 (“BBA”) to address these and other shortcomings of the TEFRA rules. The BBA repeals the TEFRA rules and replaces them with a new, centralized partnership audit regime (the “new regime”) that generally provides for assessment and collection at the partnership level. Proposed regulations were published on January 18, 2017, withdrawn on January 20, then reissued on June 14. The IRS held a public hearing on the proposed regulations on September 18, and final regulations are expected before the end of the year. The new regime generally is effective for partnership taxable years beginning on or after January 1, 2018.

Partnership-Level Assessment and Payment

Under the new regime, a partnership’s “imputed underpayment” for a tax year is assessed at the partnership level. Unlike TEFRA, the new regime does not distinguish among partnership items, affected items, computational adjustments, or non-partnership items. Instead, the IRS divides items into groups and subgroups and makes one set of adjustments at the partnership level. If the net adjustment to a particular group or subgroup is greater than zero, the IRS multiplies the adjustment by the highest rate of tax in effect for the tax year under review to arrive at the partnership’s “imputed underpayment.”

For example, assume the IRS audits the XYZ partnership for its taxable year ending December 31, 2018, and increases ordinary income by $100, increases long-term capital gain by $75, disallows $50 of deductions, and decreases long-term capital loss by $50. Under the proposed regulations, the increase to ordinary income and the disallowance of deductions are grouped, yielding a net positive adjustment of $150, and the increase to long-term capital gain and decrease to long-term capital loss are also grouped, yielding a net positive adjustment of $125. The two adjustments are then combined for a total adjustment of $275, and that adjustment is multiplied by 39.6 percent (the highest rate of tax currently in effect) to arrive at an imputed underpayment of $109.

Unless a partnership requests a modification or elects to push out the imputed underpayment to its partners, as described below, the imputed underpayment must be paid by the partnership in the year the adjustment becomes final (the “adjustment year”). The partners in the adjustment year may differ from the partners in the year under review (the “reviewed year”). Thus, under the new regime the persons who bear the economic burden of an imputed payment will not necessarily be the same persons who were partners in the partnership during the reviewed year. In addition, because adjustments are multiplied by the highest rate of tax in effect for the reviewed year, imputed underpayments often will overstate the amount of tax that would have been due had the partnership reported the items correctly.

The new regime offers two ways to mitigate this unfairness. First, a partnership that has received a Notice of Proposed Partnership Adjustment (“NOPPA”) can request a modification. Second, a partnership that has received a Notice of Final Partnership Adjustment (“FPA”) can elect to push out the liability to its reviewed year partners.


Modification is available in several circumstances. The most common involve amended returns, tax-exempt partners, and partners who are C corporations or individuals. In each of these cases, the partnership representative must request modification within 270 days of receiving the NOPPA, and the IRS must approve. If the request is approved, the IRS will reduce the partnership’s imputed underpayment to reflect the modification.

For example, assume the IRS audits the ABCD partnership for its taxable year ending December 31, 2019, and increases ABCD’s ordinary income by $500, resulting in an imputed underpayment of $198 ($500 x 39.6 percent). The partnership representative timely requests modification, and the IRS approves the request. A, who owns a 25 percent interest in ABCD, files an amended return taking into account his allocable share of the additional income ($125) and pays tax accordingly. ABCD’s partnership representative also establishes that B, who owns a 25 percent interest in ABCD, is a foreign person or tax-exempt organization that would not have been subject to tax on its share of ABCD’s income. In this example, the IRS would reduce the imputed underpayment by $99 to reflect the $250 of income allocable to A and B.

The Push Out Election

A partnership representative also may elect to “push out” the deficiency to reviewed year partners. If a partnership representative makes a push out election with respect to an imputed underpayment, the partners are liable for any increased tax on partnership items as adjusted, and the partnership is no longer liable for the imputed underpayment. The push out election must be made within 45 days of the FPA date, and notice must be sent to all of reviewed year partners. The reviewed year partners would then calculate their share of the tax, interest, and penalties (or a safe harbor amount), but would not be required to file amended tax returns for the reviewed year.

The Partnership Representative

Another significant change under the new regime is the substitution of a partnership representative for TEFRA’s tax matters partner. More than a mere name change, the partnership representative has much more authority to make decisions that are binding on the partnership and its partners. The partnership representative is empowered, for example, to extend the time periods for assessment, initiate IRS administrative appeals proceedings and litigation, agree to IRS adjustments, request modification, and make the push out election. The partnership representative’s decisions may bind the partnership and its partners even if the partnership representative exceeds his or her authority under the partnership agreement.

For example, if the partnership agreement states that the partnership representative must consult with the partners before making a push out election, but the partnership representative makes the election without first consulting the partners, the election is nevertheless valid and binding as between the partnership and the IRS.

The partnership representative is not required to be a partner in the partnership (as is the case under TEFRA) but must be a person with a “substantial presence” in the United States. The IRS made this change to address situations in which a partnership representative could not be located within the United States. The partnership representative can be an individual or an entity. However, if the partnership designates an entity to serve as the partnership representative, it must also designate an individual with a substantial presence in the U.S. to act on behalf of the partnership representative.

Electing Out

Certain partnerships are permitted to elect out of the new regime. To be eligible to elect out, a partnership must have 100 or fewer partners, and all partners must be “eligible partners.”

The number of partners in a partnership is determined based on the number of Schedules K-1 the partnership is required to issue for a particular tax year. There is a special rule for S corporation partners, however, with the S corporation counting as one partner, and each S corporation shareholder counting as an additional partner. For example, if the Acme Partnership has 50 individual partners and one S corporation partner, and the S corporation has 50 shareholders, the Acme Partnership would be deemed to have 101 partners and would be ineligible to opt out.

An eligible partner means an individual, the estate of a deceased partner, a C corporation, an S corporation, and a foreign entity that would be treated as a C corporation if it were domestic. Ineligible partners include partnerships, foreign entities that would not be treated as corporations for U.S. tax purposes, disregarded entities (including single-member LLCs) and trusts. The latter two are surprising, since single-member LLCs and certain grantor trusts are nearly always disregarded for income tax purposes, and many individuals and entities hold partnerships interests through single-member LLCs or grantor trusts.

Even if a partnership is eligible to elect out of the new regime, it may not be advisable to do so. The BBA not only enacted the new regime, but also repealed TEFRA. Thus, if a partnership elects out of the new regime, any adjustments to partnership items would have to be determined in multiple proceedings at the partner level, as was the case prior to 1982. This may be undesirable for partners in service partnerships (among others), who may prefer a single, centralized audit to the inefficiency of multiple partner-level examinations, trials and appeals.

Drafting Considerations

The new regime raises a number of important considerations that should be addressed when drafting or amending a partnership agreement. Among other things, partners should consider the following:

  • Push Out Election. Should the partnership representative make the push out election to require reviewed year partners to pay the tax associated with any audit adjustments?

  • Amended Returns. Should the partnership agreement be amended to require partners (and former partners) to file amended returns for purposes of modifying an imputed underpayment? Partnerships and partners may want to preserve flexibility on this point, since partners and former partners may object to filing amended returns to take into account small adjustments.

  • Information Sharing. Should partners and former partners be required to share information with the partnership representative for purposes of modifying an imputed underpayment? For example, should a tax-exempt or foreign partner or a C corporation partner be required to provide information that would enable the partnership representative to request modification based on such partner’s tax attributes?

  • Allocations. How should an imputed underpayment be allocated among adjustment year partners? For example, if an underpayment is reduced based on the tax attributes of certain partners, how should the reduction by shared among all partners? Surprisingly, the proposed regulations do not address this point in detail but essentially leave it up to the partnership agreement.

  • Who should serve as the partnership representative? This decision is crucial because the partnership representative will have significant authority to bind the partnership and its partners. Unlike under TEFRA, the partnership is not limited to appointing a partner, giving partnerships a broader choice of partnership representatives.

  • Contractual restrictions on the partnership representative. Because the partnership representative has such broad authority under the new regime, partnerships may want to require that the partnership representative’s decisions be approved in advance by all partners or by a select group of partners, such as an executive committee. While such provisions generally will not bind the IRS, they may allow the partners to exercise control over the partnership representative.

  • Standards for partnership representative’s decisions. Should the partnership representative be required to make decisions in the best interest of all partners or the majority of the partners? For reviewed year partners or adjustment year partners?

  • Electing out. Should the partnership elect out of the new regime if eligible to do so? Similarly, should the partnership preserve the ability to elect out by restricting transfers to ineligible partners?

Partnerships still have time to consider these and other issues and to amend their partnership agreements accordingly, as the new regime does not become effective until January 1, 2018. However, partnerships should begin planning now for how they want to address the new rules. The new regime will bring very significant changes to partnership audit procedures, and partnerships and their advisors will need to know how they want to address the changes before they are faced with an IRS audit.

© 2020 Schiff Hardin LLPNational Law Review, Volume VII, Number 277


About this Author

Virtually no business or investment activity is free from federal and state tax considerations and pitfalls. Schiff Hardin's tax attorneys advise clients on the tax aspects of the formation, financing, operation and termination of their business activities, and in the structuring of their investments.