When it comes to income taxes and IRS audits, there are a lot of procedural rules that are counter-intuitive. Even if one thinks they are half-baked, the rules are the rules. They can have serious consequences. The centralized partnership audit regime is an example.
Tax advisors often instruct their clients to elect out of the partnership audit regime. This is not an issue that most taxpayers ever think about or have an opinion about. This advice triggers the questions, “what is the centralized partnership audit regime” and “why would I elect out of the centralized partnership audit regime”? The response requires a lengthy explanation. For partnerships that qualify to elect out, the explanation goes something like this.
Why Elect out of the Partnership Audit Regime
The partnership tax rules are complex. In part, this complexity is intentional. The rules are intended to provide flexibility. The partnership tax rules are completely flexible. This allows for complex deals that would not be possible by applying the more inflexible Subchapter C or S corporation rules.
This complexity comes from the ability to compute income or loss at the partnership level, yet report the income or loss on the individual partners’ personal income tax returns. Some of the partnership tax rules are applied at the partner level and some are applied at the individual partner level.
This has made it difficult for the IRS to audit partnerships. Congress has changed the rules several times to try to accommodate the IRS, but these rules have proven difficult for the IRS to implement.
The recent Bridges v. Commissioner, T.C. Memo. 2020-51, provides an example. The case involves the TEFRA rules (described below). The IRS misapplied the rules and this should have invalided the IRS’s audit adjustment. The court considered the TEFRA safe harbor rule found in former Sec. 6231(g)(2). The court applied what amounts to a safe harbor rule for the IRS to allow what would have otherwise been an illegal assessment by the IRS.
The Bridges case is relevant as it shows the type of situation Congress intended to avoid by enacting the newer centralized partnership audit regime. The rules are intended to make it easier for the IRS to audit and make adjustments.
The explanation then turns to the higher tax that may be due under the newer regime and that the newer regime can allow the IRS to avoid the statute of limitations and conduct audits long after the statute has expired. These rules require a more thorough explanation, starting with how the IRS audits partnerships.
IRS Audits Involving Partnerships
There is a saying that what is old is new. That saying is fitting here. Before we get into the centralized audit regime, we should stop to consider the old partnership audit rules. As explained below, these old rules are once again the current rules for many taxpayers.
The old partnership rules often worked in the taxpayer’s favor. One way they did this was that they discouraged the IRS from auditing partnership returns. The old partnership rules put the burden on the IRS and its auditors. The IRS and its auditors had to open audits for each individual partner. To the IRS auditor who normally carries between 1 and 100 audits at any given time (which varies over time and based on the IRS auditor’s role and function), this means that the IRS auditor would have to open an entirely separate audit for each individual partner’s tax return.
Imagine a partnership that had 1,000 partners. This means that the IRS auditor would have to open 1,000 individual audits–one for each tax return filed by the partners. Of the 1,000 individual audits, each one had to be opened in the IRS computer system, each partner had to be mailed notices, etc., and each partner had the ability and right to interact with the IRS auditor. And when the IRS audit was closed out, the IRS auditor would have to send notices to each individual partner. Each partner could then challenge the notice either in Appeals or in court. And each partner could challenge the collection of the tax.
This problem is compounded when you factor in the IRS’s antiquated paper-form processing procedures. The IRS does not leverage technology appropriately. The paperwork and forms the IRS requires to even open and close a single IRS audit are extreme. Most of the IRS’s paper-based case management processes haven’t hanged in more than five decades. In fact, some of the IRS’s correspondence and forms have never been changed (when I worked there, I came across a letter in an active case file that was written by the IRS in 1942; the letter was word-for-word the same as the letter the IRS was still using more than sixty years later).
Suffice it to say that the IRS’s auditors did not (and still do not) have the resources to handle this volume of partnership audits. This is particularly true for larger partnerships and for large tax adjustments that are not large adjustments when divided among several hundred or several thousand individual partners.
Historically, the IRS would simply not audit these larger partnership returns. This was even true for smaller partnerships. When it did audit them, it would often only audit one or a few of the individual partners. When it determined to make a tax adjustment on audit, the IRS would only make adjustments for the partner or partners who had the largest partnership stake. It would skip the other partners.
Congress attempted to remedy this in The Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”), which was addressed in the Bridges case cited above, and then the centralized partnership audit regime in the Bipartisan Budget Act of 2015 (“BBA”).
The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA)
To understand the newer centralized partnership audit regime, we have to consider the TEFRA rules.
The TEFRA rules allowed the IRS to conduct the audit at the partnership level for larger partnerships. The IRS auditor worked with the partnership’s tax matter partner. Any settlement or IRS adjustment for the partnership was binding on the individual partners.
Importantly, the time period for assessing tax against the partnership was determined at the partnership level. This allowed the IRS auditor to track one statute of limitation for the audit, rather than several different limitation periods for each of the partners. But with TEFRA, the IRS still had to collect the tax from the individual partners.
It was not always clear when the TEFRA rules applied. The TEFRA rules only applied to partnerships with 10 or more partners or those who elected to apply the rules. Spouses filing joint tax returns were treated as one taxpayer.
At the start of the IRS audit, the IRS had to decide whether the TEFRA rules apply. If the TEFRA rules did not apply, the statute of limitations on assessing tax would apply at the individual partner level. If they applied, the IRS had to track the statute of limitations on assessing tax at the partnership level.
This was problematic for the IRS as the IRS does not start IRS audits timely and its agents often fail to work the audits timely. It was (and still is) common for the IRS auditors to have to request the taxpayer sign a consent form to extend the three-year assessment period provided by Congress.
With TEFRA audits, consent had to be secured at the partnership level. Absent TEFRA, the consent had to be secured by the individual partners. Consents signed by the tax matters partner were not valid to extend the statute for assessing tax for the individual partners. So if the IRS erred in determining that the TEFRA rules applied, the IRS’s tax assessments would often not be timely. This was was a big problem for the IRS and its auditors.
The opposite was also true. There were other TEFRA notice rules that the IRS had to comply with. Failure to satisfy these TEFRA rules could result in the IRS not being able to assess additional tax. This too could invalidate IRS audit adjustments.
The Centralized Partnership Audit Regime
This brings us to the centralized partnership audit regime in the BBA. It applies to all tax years starting in 2018.
The BBA was intended to remedy the problems posed by TEFRA. It was intended to make it easier for the IRS to audit large taxpayers and to do so without worrying about procedural foot faults.
The centralized partnership audit regime functions like the TEFRA rules. Like the TEFRA rules, it allows the IRS auditor to make adjustments at the partnership level. This is true even if the partner is in a lower tax bracket. The partnership-level adjustments are assessed based on the highest rate of tax for the tax year. Worse yet, the assessment is made in the year the IRS proposes the adjustment–not the tax year. The centralized partnership audit regime goes further and allows the IRS to collect the tax from the partnership. The centralized partnership audit regime also allows IRS auditors to control the audit at the partnership level.
The BBA creates procedural and economic effects that differ from previous tax laws, such as TEFRA. One of the differences is that the BBA separates the year under audit from the adjustment year, which is the year in which payment of the imputed underpayment becomes due. This can have economic implications for partners, as the entity liable for the underpayment (the partnership) may be different from the individuals who bear the economic burden of the underpayment (the partners in the adjustment year).
Also, it is not clear whether partners who participate in modifying the partnership’s proposed imputed underpayment are treated differently regarding penalties and interest from those who don’t participate in the modification procedure. In other words, there may be additional procedural and economic complexities that arise from this tax law.
This can raise a number of unfair situations, such as when a new partner joins and the IRS assesses tax for a prior year. These rules essentially shift the burden of dealing with these issues to the partnership and partners. The partnership and partners are expected to deal with these issues among themselves. For those who plan in advance, this can mostly be done in the partnership agreement. For others (which is most taxpayers), it may have to be an after-the-fact negotiation process among the partners.
Electing Out of The Centralized Partnership Audit Regime
To avoid the problems with the centralized partnership audit regime, the rules allow some taxpayers are able to elect out of the centralized partnership audit regime. This gets to the “why should I opt out of the centralized partnership audit regime” explanation.
For individual partners who are invested in the partnership and not expected to exit soon, they may prefer that the partnership elect out. Electing out puts the individual partners back in the same regime they were before TEFRA and before the centralized partnership audit regime was in place. It puts the onus back on the IRS to open and manage individual IRS audits. The IRS is likely to not audit these partnership returns or, if it does, that will not audit every partner. This can save the individual partners the time and expense of dealing with an IRS audit and avoid IRS audit adjustments.
The rules do not allow every taxpayer to elect out of the centralized partnership audit regime. To qualify to elect out, the partnership has to make an election by checking a box on the partnership tax return each year. And every partner has to be an individual, a C corporation, a foreign entity that would be treated as a C corporation if it were domestic, an S corporation, or an estate of a deceased partner. The partnership cannot elect out if it has a single partner that is outside of these categories.
If the partnership fails to elect out timely, all is not lost. The rules provide an alternative method for passing the IRS audit adjustment on to the partners. This is done by the partnership electing out of the audit regime within 45 days of the IRS’s final audit adjustment notice. This wait-and-see approach is not as favorable as electing out on a timely filed tax return, as it provides the IRS with the ability to open and manage the IRS audit at the partnership level.
Planning to Elect Out
As tax attorneys in Houston, we work with a lot of partnerships. They are the preferred choice of entity in Texas. This is partially due to the oil and gas deals and businesses in Texas. The flexibility makes it possible to customize deals and allocate and manage risk appropriately.
We continue to see partnership agreements and LLC company agreements that do not address the centralized partnership audit regime rules or issues that come from them.
Those electing out of the centralized partnership audit regime should consider addressing the issues raised by these rules in their partnership agreements. At a minimum, they should consider including language:
- Barring new partners that would prevent the partnership from electing out of the centralized partnership audit regime. This would include disregarded entities and grantor trusts.
- Allowing the partners with access to records to defend IRS audits.
- Providing backup rules that apply if the partnership election out is not made or found to be invalid for one or more tax years, including designating the partnership representative, explaining how any tax adjustment will be allocated and possibly including a clawback for former partners, etc.
Every partnership agreement should address these issues. For partnerships that were formed prior to 2018, the agreements should be updated to address these issues. For M&A deals involving partnerships, the deal documents should address these issues.