Under the default rule, any adjustment to partnership items or allocations among the partners will be determined, and any tax (including interest and penalties) attributable to adjustments will be collected, at the partnership level. Each partnership will be required to designate a “partnership representative” with authority to act on behalf of the partnership. Unlike the former “tax matters partner” regime, the partnership representative does not need to be a partner for tax purposes, so designation of a non-economic managing member or non-member manager is now expressly permitted. Furthermore, the IRS will no longer be required to notify other partners of the partnership proceedings (unlike the former “notice partner” regime), and partners will no longer be permitted to opt-in to a separate partner-level proceeding in order to avoid being bound by the partnership proceeding.
The rules will apply to all partnerships, but a partnership may elect out of the application of such rules if it has 100 or fewer partners, and its partners consist solely of individuals (including estates of deceased partners), C-corporations (including any foreign entity that would be treated as a C-corporation were it domestic) and S-corporations. For purposes of the 100 partner threshold, each S-corporation shareholder is treated as a partner of the partnership. Most notably, a partnership that has one or more upper-tier partnerships as partners (such as a typical investment fund with a general partner that is itself a partnership) will not qualify for the opt-out. The new rules will apply to both new and existing partnerships for their taxable years beginning after December 31, 2017, although a partnership may elect to apply such rules for partnership taxable years beginning after November 2, 2015.
The “Imputed Underpayment” System
In the event of any adjustment to partnership items or allocations, the new rules generally require the partnership to pay tax on the “imputed underpayment” resulting from the adjustment, plus interest and any applicable penalties. The imputed underpayment is determined based on the highest rate of tax applicable to either individuals or corporations in effect for the audited year. It is not clear from the statute what the consequences are to a partnership or its partners with respect to an adjustment that relates solely to a change in character of a taxable item (other than as it relates to capital gain or qualified dividend treatment versus ordinary income). In the case of adjustments to allocations among partners, only increases in income allocated to partners are taken into account in the calculation of the imputed underpayment—not the corresponding decreases in income allocations (or increases in expense allocations) to other partners. In the case of adjustments that do not result in an imputed underpayment (e.g., decreases in taxable items, increases in deduction or loss, and decreases in income allocated to a partner), such adjustments are reported by that partnership to its partners in the taxable year in which the adjustment is finally determined—not the year being audited.
The Act directs the Treasury Department to establish procedures by which the IRS can approve of a partnership reducing the imputed underpayment in the following circumstances. First, if one or more partners agree to file amended returns for the reviewed year that take into account the applicable adjustment allocable to the partner and the partner pays any resulting tax due along with the return, that partner’s share of the adjustment can be excluded from calculation of the imputed underpayment to be paid by the partnership. Second, the partnership can exclude any portion of the adjustment that it can demonstrate is allocable to a U.S. tax-exempt or non-U.S. partner that would not be required to pay tax on the adjustment. Finally, the partnership can adjust the rate of tax used in the calculation of the imputed underpayment to the extent it can demonstrate that a partner will be subject to a lower rate of tax on the type of income being adjusted (e.g., capital gains allocable to an individual or ordinary income allocable to a corporation).
It is not clear from the statute what the impact a partnership adjustment and subsequent payment of any imputed underpayment by a partnership may have on such partnership’s current partners. However, any adjustment paid by the partnership will not be deductible to the partners for U.S. federal income tax purposes.
The Alternative Method
The Act permits partnerships to elect to avoid paying tax under the imputed underpayment approach at the partnership level. Under this alternative method, the partnership must send a statement to each person who was a partner during the year reviewed on audit setting forth such partner’s share of any adjustments, including any adjustments to subsequent years resulting from the adjustment to the reviewed year. This statement is not an amended K-1 for the year audited, but rather a statement for the current taxable year. Each partner is then required to pay an additional tax for the taxable year in which the partner receives the statement, rather than filing amended returns for the years adjusted. The additional tax is determined based on the amount of additional taxes that would have been payable in the year under the audit (and any intervening years) had the partner taken the adjustment into account in the year under audit, plus interest and any applicable penalties as if the tax was due in the year under audit. This alternative method potentially comes with a cost; interest is imposed at the partner level at the federal short-term rate plus five percentage points, a rate that is two percentage points higher than the rate that is typically applied. On the other hand, as compared to the default rule, the alternative method more accurately matches the additional taxes borne by a partner to such partner’s tax attributes and avoids economic distortions.
Partnership Requests for Adjustments
Under the Act, partnerships will no longer be permitted to amend their tax returns and distribute revised K-1s to their partners. Rather, partnerships will have to follow procedures similar to those with respect to audits, so that any adjustments would be taken into account in the year in which the request for adjustment is made.
Partners That Are Pass-Through Entities
The Act leaves significant questions outstanding for partnerships that have partners that themselves are partnerships or other pass-through entities like RICs, REITs, or certain trusts (“pass-through partners”). It is not clear how the reductions that are permitted to be made to the imputed underpayment amount will apply in the case of pass-through partners. Even if the Treasury Department enacts regulations or other guidance on applying the reductions to pass-through partners that are partnerships, it may not be administratively feasible for partnerships to utilize this method if it requires their pass-through partners to provide agreements from their own partners to file amended tax returns, and there may not be a straightforward manner to apply the method to RICs and REITs. Similar uncertainties and challenges apply with respect to partnerships with pass-through partners that may seek to use the alternative method.
The Act has both positive and negative implications for partnerships, depending on their circumstances. The new rules can be very helpful in permitting a partnership to manage IRS audits without the negative ramifications of its partners being required to receive amended K-1s and amend prior year tax returns—especially for partnerships with limited ownership changes. On the other hand, in many cases some partners will be better off with a partner-level assessment under the more complex alternative method. For investors in existing partnerships, for example, the default method creates a new risk that the partnership itself could be required to pay taxes that are attributable to a liability that should have been paid by the pre-existing partners in respect of a past tax year. The new rules also substantially eliminate a partner’s ability to contest partnership items on his or her own. Instead, to protect against these types of situations, partners may seek more contractual protection in the partnership agreement. On the other hand, a partnership could have substantially greater administrative burdens in managing audits if it grants one or more of its partners enhanced rights in respect of tax proceedings and may find itself unable to manage audits and other tax proceedings effectively and efficiently. Partnerships, and partners in existing and future partnerships, should carefully consider what, if any, amendments to their governing agreements are warranted in light of these changes.
If you have any questions about this alert, please contact a member of our tax practice.