In the waning days of 2018, the IRS released final regulations on the new partnership audit rules under the Bipartisan Budget Act of 2015 (BBA). While these rules are typically thought of in the for-profit context, they can have a significant impact on exempt organizations whose investment portfolios include alternatives.
Specifically, due to the way the partnership audit rules work, it is important for exempt organizations investing in entities classified as partnerships for tax purposes to address the BBA rules explicitly in side letters for fund investments to avoid potential private benefit issues. In this post, I review the background of the rules and the impact on exempt organizations. This summary is based on a panel I recently participated on at the January 2019 American Bar Association Tax Section meeting in New Orleans. You can find the technical outline (of which I am co-author) from that meeting here, which explores these issues in much greater depth.
Under former law, for most partnerships, the IRS conducted audits at the partner level but was required to assess tax against each partner from the audit year individually. The new rules, adopted as part of the Bipartisan Budget Act of 2015 and effective for tax years beginning after December 31, 2017, change both how the IRS audits partnerships and who pays tax on audit adjustments.
Under the BBA, the IRS generally will assess tax against the partnership itself for any underpayments discovered under audit. This represents a change to the fundamental proposition that partnerships themselves are not taxpayers for income tax purposes. Tax is assessed in the year the audit is complete. This change shifts the economic burden of an adjustment to partners in the audit year, rather than the reviewed year. In other words, the “wrong partner” can end up paying the tax.
While this makes collection easier for the IRS, it may not make economic sense in the absence of contractual provisions that remedy the situation. The partnership agreements and/or documents related to the transfer of partnership interests will need to specifically engage with this issue to ensure that the persons that were actually partners in the year that the underpayment occurred bear the burden of the tax, and in the right proportions. Purchasers of partnership interests and other new partners need to make sure that they are contractually protected against liabilities prior to their becoming a partner. While these issues apply to all partners, special issues are presented for tax-exempt partners as described below.
When tax is assessed on the underpayment, it is due at the highest tax rate applicable in the reviewed year. The tax can be reduced including, as relevant here, if the partnership can show that a portion of the adjustment would be allocable to an organization that would not owe tax because it is a tax-exempt entity. We recommend language that requires a partnership to use, at the very least, commercially reasonable efforts to obtain this modification.
For tax-exempt investors, the decision whether or not to request an adjustment may potentially give rise to private benefit concerns. The preamble to the proposed regulations contains the following observation on this subject:
A partnership’s decision either to request or not to request modification in the course of an audit under these proposed regulations may raise issues concerning whether and to what extent any benefit that might result from its request or failure to request modification could be considered to have been provided to any person in lieu of to a tax-exempt partner (whether a current or former partner, and at any “tier” of the partnership). For example, such a transfer of benefit may raise issues for one or more partners with respect to … the status of a tax-exempt partner because of private inurement or private benefit under section 501(c).... Some of these issues may be addressed by including appropriate provisions in the partnership agreement. However, the Treasury Department and the IRS request comments from the public on whether guidance is needed to address these potential issues and, if so, on possible ways to resolve such issues.
(Despite the IRS’s request for comment, no comments were received related to these exempt organization issues. In the preamble to the final rules, the IRS explicitly noted that it did not receive comments on this issue, and stated that it will still consider them—a clear indication that the IRS wants to hear from the exempt organization community on this.)
As an alternative to requesting an adjustment, the new law allows the partnership to elect for the persons that were partners in the year under audit to pay the tax (referred to as “push out” election). The partners report the tax, with interest (at an increased rate), on their returns for the year in which the adjustment is made. This solves the potential private benefit issue, as an exempt organization receiving push out income simply would not owe any tax. However, as stated by the IRS in the preamble, push outs present other potential issues:
The Treasury Department and the IRS request comments from the public on whether guidance is needed on how to address potential issues arising with respect to tax-exempt entities as a result of an election under section 6226 and, if so, on possible ways to resolve such issues. For instance, if a tax exempt entity’s share of the amounts under section 6226 is investment income, issues may arise regarding how a section 6226 election might affect the entity’s public support calculation (if the entity is a publicly-supported organization) or the applicable net investment income tax (if the entity is a private foundation).
The partnership agreement or side letter can engage with whether the push out election may be made, as described in further detail in the technical outline from the ABA panel.
Under the BBA, partnerships may appoint any person or entity with substantial presence in the U.S. to serve as the “partnership representative” before the IRS. (These can actually include tax-exempt organizations, though they would be an unusual choice.) This replaces the old concept of the “tax matters partner” who had to be a partner of the partnership.
The BBA rules make all decisions of the partnership representative binding on the partnership and provide that the partners are not entitled to notice of audits or adjustments. To ensure that all partners are treated fairly, the partnership agreement or side letter should include contractual provisions which, at the very least, require the representative to keep the other partners apprised of audit activity.
The new rules apply to all partnerships, unless the partnership elects out. Partnerships are eligible to elect out of the new rules if they issue 100 or fewer Schedule K-1s for the tax year and have no partners that are entities taxed as partnerships or are otherwise disqualified.
While the election out may not be available for most investment partnerships, for eligible partnerships there may be advantages to electing out. If a partnership elects out, the IRS may still audit the partnership, but must make adjustments at the individual partner level. This makes the audit process much more difficult for the IRS and also avoids all of the technical issues for exempt organizations presented by the new rules. The decision must be made in advance on the timely filed return for each tax year. Accordingly, partnerships will need to make this determination in the coming months for the 2018 tax year as partnership returns will be due.
The BBA rules are intended to make it easier for the IRS to audit partnerships and they certainly do that. However, they are a blunt instrument that can result in the “wrong partner” bearing economic responsibility for partnership adjustments. These issues can be particularly troubling where an exempt organization is a partner. Exempt investors will need to address the new rules in side letters in the context of fund investments. The ABA technical outline provides sample language that may be helpful in this regard.