October 21, 2021

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Partnership-Level Tax Under New Audit Rules

The Bipartisan Budget Act of 2015, signed into law on November 2, 2015, has significantly changed the partnership tax audit rules, effective for tax years beginning after December 31, 2017.

Under the current partnership audit rules, after an audit adjustment, the IRS must separately assess and collect tax from each partner. For large partnerships in particular, this can be a lengthy and administratively burdensome process for the IRS.

The new rules will impose an entity-level tax on a partnership that is subject to an audit adjustment (plus interest and penalties, as applicable). Unlike prior legislative proposals, however, partners will not be jointly and severally liable for the entire audit tax liability. The partnership will not be able to deduct this entity-level tax (or any associated interest or penalties). The partnership's tax liability initially is calculated by multiplying all net adjustments by the highest marginal federal rate (currently, 39.6%). The partnership may then take certain actions to try to reduce this initial calculation (described in more detail below), or the partnership may elect for each of its partners to pay their respective shares of the tax, rather than the partnership itself. In either case, the burden of the partnership audit will shift significantly from the IRS to the partnership, which may dramatically increase the number of partnership audits by the IRS.

Reducing Initial Tax Calculation. A partnership's tax liability can be reduced if (1) partners file amended returns to reflect the partnership's audit adjustments (for all affected tax years), (2) the partnership demonstrates that adjustments would be allocable either to tax-exempt or non-U.S. partners who would not be taxable on those allocations, (3) the partnership demonstrates that adjustment allocations would benefit from preferential rates (i.e., capital gain or qualified dividend income allocable to an individual or ordinary income allocable to a corporation), or (4) otherwise determined by future guidance.

Election to Shift Tax Payment to Partners. As mentioned above, a partnership can elect for each of its partners to pay their respective share of the audit tax liability. The partnership must issue a statement to each partner with the information necessary for each partner to calculate such partner's tax liability resulting from the audit. If the partnership elects this "flow-through" option, interest and penalties are also assessed at the partner level, but with interest payable at a rate that is 2% higher than the generally applicable rate.

Limited Ability to Opt Out of the New Rules. Partnerships can elect to opt-out of the new rules if they have 100 or fewer partners consisting exclusively of individuals, corporations or estates. Any partnership with even a single partner (whether a limited partner or the general partner) that is a partnership for U.S. tax purposes cannot opt out.  Accordingly, virtually all private investment funds will be subject to these new rules.

Partnership Representative to Bind All Partners. The new rules also repeal the various participation rights and procedural safeguards currently enjoyed by many partners in partnership-level administrative and judicial proceedings. Instead of appointing a "tax matters partner," partnerships must designate a partnership representative who need not be a partner but who must have a "substantial presence" in the United States. The new rules grant the partnership representative the sole authority to act for and bind the partnership (and its partners) in all IRS disputes.

Former Partners may Escape Liability. If a partner transfers its interest before a partnership tax audit, the transferee will indirectly bear the burden of any tax liability paid by the partnership, even if the audit was in respect of a prior year. However, if the partnership elects for its partners to pay the tax liability, the transferor will be liable.

Amending Partnership Agreements. The new rules also raise a number of issues for partners, many of which will need to be addressed through new provisions in partnership agreements. Such issues include the following:

  • Who will be the partnership representative?

  • Who will determine whether the partnership pays any audit tax liability or whether the election is made to shift the burden to the partners?

  • If the partnership pays an audit tax liability, how will the economic burden be shared among the partners?

  • Will a partnership require its partners to provide information to the partnership or to file amended returns in order to reduce the amount of any audit tax liability?

  • What rights will partners have regarding tax disputes? Absent contractual protections, the statute now gives full authority to the partnership representative.

© 2021 Proskauer Rose LLP. National Law Review, Volume V, Number 310

About this Author

Scott Jones, Tax Attorney, Proskauer Rose Law Firm

Scott S. Jones is a Partner in the Tax Department and a member of the Private Investment Funds Group.

Mary B Kuusisto, Tax Attorney, Proskauer Rose Law Firm

Mary B. Kuusisto is a partner in the Private Investment Funds Group and a member of the Tax Department.

Mary has almost 20 years of experience in the private equity industry. She advises clients on structuring and operations of private investment funds globally, with particular experience in tax-related matters. She has represented hundreds of private investment funds in their formation and operational activities, including venture capital, buyout, distressed debt, mezzanine finance, natural resource, secondary, and funds of funds, as well as...

Amanda Nussbaum, Tax Attorney, Proskauer Rose Law Firm

Amanda H. Nussbaum is a Partner in the Tax Department and also is a member of the Private Investment Funds Group. Her practice concentrates on planning for and the structuring of domestic and international private investment funds, including venture capital, buyout, real estate and hedge funds, as well as advising those funds on investment activities and operational issues. She also represents many types of investors, including tax-exempt and non-U.S. investors, with their investments in private investment funds.

D Alexander Campbell, Proskauer Rose, UK Tax Attorney, Capital Funds lawyer

Alec Campbell is an associate in the Tax Department and a member of the Private Investment Funds Group.

Alec's practice focuses on the formation and operation of private investment funds, including venture capital funds, buyout funds, funds-of-funds, secondary funds and other investment partnerships.

Prior to joining Proskauer, Alec was an associate in the Tax Department at Cahill Gordon & Reindel, LLP, where he advised clients on the tax aspects of securities offerings and financing arrangements.

Howard Beber, Tax Attorney, Proskauer Rose Law Firm

Howard J. Beber is a partner in the Corporate Department and co-head of the Private Funds Group, which is recognized by Chambers GlobalChambers USA and US Legal 500. His practice focuses on representing private equity funds and institutional investors on a broad range of issues including fund formations, secondary transactions and portfolio investments. 

Howard is actively involved in all stages of fund formation and fund sponsor representation, counseling on terms and marketing strategy, preparing offering documents...